Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Delving into Fiscal Policy

Turn on the news and you’re likely to see some politician talking about fiscal policy, or more accurately what should happen to government spending or taxation. If you listen carefully to what’s said, you may notice that what’s promised is higher spending on some social programme or lower taxes for the public.

These statements sound peculiar to economists, because higher government spending has to be paid for somehow, either by reducing spending elsewhere or by increasing taxes now or in the future. Similarly, lowering taxes means less revenue for the government and therefore less government spending now or in the future.

In this section we show you why this restriction on a government’s freedom of choice has to exist, the details of debt and deficits (often the result of the constraint) and how governments can raise their revenue.

Acknowledging that governments face budget constraints
The fact that politicians tend to focus on the positives and ignore the negatives isn’t surprising, but people need to be clear about the following:


Promising more government spending is equivalent to promising higher taxes, now or in the future.


Promising lower taxes is equivalent to promising lower government spending, now or in the future.

But why can’t the government just increase spending without increasing taxes at some point in the future? The reason is that the government, much like a household, faces its own intertemporal budget

constraint (intertemporal just means ‘across time’), which constrains the kinds of choices it can make.


Thinking of a household’s budget constraint

The easiest way to explain the intertemporal budget constraint is to think about it in terms of a household that lives for two time periods, t = 1, 2:

In time period 1, the household receives income equal to y₁ and has to decide how much to consume, c₁.


In time period 2, the household receives income equal to y₂ and has to decide how much to consume, c₂.


If the household decides to save some of its income in time period 1, this amount (y₁ – c₁) is put into a savings account and earns an interest rate equal to r. (Alternatively, the household could decide to borrow in period 1 from its period 2 income, in which case it would have to pay interest at rate r.)

The question is: what’s the relationship between all these variables? Well, in period 2 the household has to decide how much to consume: after all, it’s the final period and so no point saving anything – it may as well consume as much as it possibly can! With this in mind, period 2 consumption must equal:

In words, this equation says that in period 2, the household should consume all its income in that period plus all its savings.

Notice that the savings term (y₁ – c₁) is multiplied by (1 + r) because of the return it earns. For example, if the interest rate is r = 5 per cent and the household saves £100 in period 1, by period 2 its savings would’ve grown to £105 = (1.05)(£100).

This equation must still be true even if the household borrows in period 1: that is, it consumes more than its income (c₁ > y₁). Except that now y₁ – c₁ is negative and represents the household’s borrowing in period 1. It’s also multiplied by (1 + r), because interest must be paid on the loan.

If you divide both sides of the equation by (1 + r) and rearrange, you get:


This equation says something interesting: the net present value (NPV) of consumption better be equal to the NPV of income. The NPV of something is the equivalent value of it in terms of money today.

For example, the NPV of getting £100 today is clearly £100. But what about the NPV of £100 in one year’s time? Is it still £100? Well, what would you prefer: £100 today or £100 in a year’s time? Most people go for the £100 today – therefore, the NPV of £100 in a year’s time is less than £100. Getting £100 next year just isn’t as good as getting it today.

But then how good is getting £100 next year in terms of money today: in other words, what’s the NPV of £100 next year?