ECO-5007B: Consider a two-period economy with a household and government: Intermediate Macroeconomics Assignment, UEA, UK

University University of East Anglia (UEA)
Subject ECO-5007B: Intermediate Macroeconomics Assignment

Question 1 [10 marks]

Consider a twoperiod economy with a household and government.

The household behaves according to its intertemporal budget constraint, but faces a borrowing constraint that prevents period1 consumption from exceeding period1 disposable income, which can be written as follows,

Here 𝐢 is consumption, 𝑇 is taxation, 𝐺 is government expenditure, and π‘Ÿ 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‘Ÿ. Further, suppose that the household has a preference for consumption today, such that its borrowing constraint is binding, forcing it to consume its period1 income today and period2 income tomorrow. That is to say, initially 𝐢1 = (π‘Œ1 βˆ’ 𝑇1) and 𝐢2 = (π‘Œ2 βˆ’ 𝑇2).

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 𝐺1 and 𝐺2, but it cuts taxes to 𝑇1β€² in period 1 and consequently increases taxes to 𝑇2β€² in period 2, to still obey its intertemporal budget constraint.

Is the fiscal policy via the tax cut effective at
stimulating period1 consumption? Draw a diagram and provide clear explanation about how this example relates to Ricardian Equivalence.

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