Trigger Points and Budget Cuts: Explaining the Effects of Fiscal Austerity

We propose and solve an optimizing model which explains counterintuitive effects of fiscal policy in terms of expectations. If government spending follows an upward-trending stochastic process which the public believes may fall sharply when it reaches specific "target points," then optimizing consumption behavior and simple budget constraint arithmetic imply a nonlinear relationship between private consumption and government spending. This theoretical relation is consistent with the experience of several countries.