No. 426 - Consumption and fiscal policies: medium-run non-Keynesian effects

In this paper we study the effects of fiscal policies on current consumption, distinguishing between Keynesian effects (KE), due to changes in current disposable income, and non-Keynesian effects (NE), due to expected changes in future disposable income. The literature has argued that permanent changes in fiscal policies affect current consumption. We show that the size and sign of such NE effects depend crucially on the expected lifetime of the representative consumer and on the timing of policy changes. In particular we investigate the effects on current consumption of medium run changes in fiscal policy. Using a consumption function based on a perpetual youth model, formulated in discrete time, we show the possibility of reversed NE effects where sign (KE) = sign (NE). All that is required for such reversed NE effects is the satisfaction of a simple and realistic condition depending on the expected lifetime of the consumer and the starting date for the offsetting fiscal measures needed to satisfy the intertemporal public sector budget constraint. We propose a number of exercises showing the importance of the level and dynamics of public debt. The results help to explain anomalous trends in consumption during 90s, as Italy prepared to join the EMU.