Answer to Question #193198 in Macroeconomics for Diya

Question

Assume consumers with standard preferences live for two periods. They receive an income in each period (𝑦 and 𝑦′) and pay lump-sum taxes to the government in each period (𝑡 and 𝑡′ ). The credit market is perfect,

i.e. every borrower repays its debts. Let us suppose that the government increases government spending in

the first period (𝐺 increases, 𝐺′ does not change). At the same time the government reduces taxes in the

first period (𝑡 < 𝑡 ) and increases taxes in the second period (𝑡′ > 𝑡′ ) in such a way that the new 21 21

government intertemporal budget constraint with the new government spending level is satisfied. After these policy changes:

a) Borrowers will definitely borrow more

b) Lenders will definitely save more

c) Nothing changes as Ricardian equivalence holds.

d) Current consumption will be lower

e) Current consumption will be the same

Answer 1

The correct options are:

b) Lenders will definitely save more

c) Nothing changes as Ricardian equivalence holds. and

e) Current consumption will be the same

Explanation

This is so because it is correct that lenders will definitely save more because there is a high-interest rate and lenders will receive a good return on lending and in the second period, they will save more such that to finance the taxes increment in that period.

It is also correct that nothing changes as Ricardian equivalence holds this is so because it demonstrates that consumers will incorporate the government intertemporal budget constraints and thus will do their consumption and saving accordingly. Thus there will be no change because the expansionary fiscal policy adopted by the government in the first period will be offset by the taxes which have to be paid in the future during the second period. Hence, there will be higher savings in the first period and fewer savings in the second period & consumption will remain the same.

It is also correct that current consumption will be the same because they are aware that today's lower tax will result in higher payment of taxes in the future and this is stated by the Ricardian equivalence.

Why A and D are incorrect

Option A is incorrect that is borrowers will definitely borrow less because the expansionary fiscal policy in the first period will result in a high interest rate which raises the cost of borrowing and therefore the borrowers will borrow less.

Option D is also incorrect because the consumption level in both the time period will remain the same as explained in the above step.