Answer to Question #173995 in Macroeconomics for John

Question

Ramsay model including stochastic element. Policy function now: c∗t (kt) = (1 − αβ)A(kt)^αlpha,  

and thus function. kt+1(kt) = αβAkt + εt. Decribe how the ramsay model is effected by this after a temporary shock to investment

Answer 1

There will be an upward shift in public spending since it goes hand in hand with higher lump-sum taxes so as to maintain a balanced budget. As a result, the after-tax human wealth of the household at the given time is immediately reduced. As the households are now less wealthy, the private consumption immediately drops