Question 1 [10 marks]
Consider a twoβperiod economy with a household and government.
The household behaves according to its intertemporal budget constraint, but faces a borrowing constraint that prevents periodβ1 consumption from exceeding periodβ1 disposable income, which can be written as follows,
Here πΆ is consumption, π is taxation, πΊ is government expenditure, and π is the real interest rate. Subscripts denote periods 1 and 2.
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You may assume that household and government face the same real interest rate, π. Further, suppose that the household has a preference for consumption today, such that its borrowing constraint is binding, forcing it to consume its periodβ1 income today and periodβ2 income tomorrow. That is to say, initially πΆ1 = (π1 β π1) and πΆ2 = (π2 β π2).
This situation is shown in the following diagram.
Now consider a situation where the government tries to stimulate the economy via a tax cut in period 1. The government maintains expenditure in each period at πΊ1 and πΊ2, but it cuts taxes to π1β² in period 1 and consequently increases taxes to π2β² in period 2, to still obey its intertemporal budget constraint.
Is the fiscal policy via the tax cut effective at stimulating periodβ1 consumption? Draw a diagram and provide clear explanation about how this example relates to Ricardian Equivalence.
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