Saturday, October 22, 2011

Household behaviour that counteracts fiscal expansion

Suppose a government tries to boost demand in the economy by boosting the deficit.

A fascinating feature of the situation is: Households are not wood, households are not stones, but men. And being men, they will look forward, they will optimise. Households know that all government expenditure requries taxation: all that is achieved by running a deficit today is postponing taxes to tomorrow.

India's fiscal stance is now likely to lead to increased taxation in the future. We have a nice wide deficit today, but it's increasingly likely that fresh taxation will come up in the future.

A core feature of human beings is that we do not like to deal with fluctuations in our consumption. So faced with the prospect of taxation tomorrow, we are prone to cut back on consumption today.

Through this, when a government raises the deficit today, some of this effect is counteracted by households that pull back on expenditure. Raising the fiscal deficit is less expansionary than some would think.

Economists have a fancy name for this: it's called Ricardian Equivalence. This was originally thought up by David Ricardo, but made famous by Robert Barro. It is one of the many ways in which forward looking households are of essence in thinking about macroeconomics. "You are not wood, you are not stones, but men; and being men, you will optimise".

LaTeX mathematics works. This means that if you want to say $10 you have to say \$10.