Consider an initial situation in which (g1, g2) = (0, 0) and suppose that households are initially content with consuming their endowment; i.e., point A in Figure 5.2 (remember that where you place the initial indifference curve does not matter). A transitory increase in government spending can be modeled as Δg1 > 0 and Δg2 = 0. We are assuming here that Δτ1 = Δg1, but remember that whether the government finances this increase with higher current taxes or a deficit (higher future taxes) will not matter.
This fiscal policy shifts the after-tax endowment point to the left (i.e., to point B). The higher tax burden makes households less wealthy. The consumption smoothing motive (i.e., the wealth effect) implies that generally speaking, households will react to this fiscal policy by reducing their demand for consumption at all dates; i.e., ΔcD1 < 0 and ΔcD2.< 0.
