Answer to Question #266186 in Macroeconomics for Kyle K

Question

Consider a two-period economy populated with consumers that have the same income and the same preferences. G = 60, G' = 150. The government can borrow in the current period by issuing bonds. Each bond pays the real interest rate r. Consumers can also borrow at the same real interest rate r. Consumers’ optimal decisions, given r, imply that AG C* = 2/3 (Y− T) + 2/3 (Y' - T')/(1+r). Suppose that Y=Y' = 300.

Economic activity falls by 18 units in the current period. This recession is expected to continue and national income is expected to fall by 20 units in the future period. Consumers believe these expectations.

A) Calculate AD given the current period and recession.

B) Use a graph to explain why the equilibrium interest rate falls from 0.25 to 0.20

C) Explain why the government should not increase its expenditure G

D) Would a tax cut in the current period, that is decrease in T, be a better choice than an increase in G to fight this recession? Explain, why or why not.

Answer 1

The recession of period 0 can be fought using a tax rate cut. During recession, consumers generally decrease their spending and add to their savings. Expansionary monetary policies such as tax rate cuts help to increase aggregate demand and stabilize the economy. This decrease in the tax rate will put more disposable income in the hands of the consumers which they can spend on goods and services. This will increase their purchasing power and increase their aggregate consumption. As we see in the equation given, if $TO$ decreases, $CO^*$ will increase. This will shift the aggregate demand to the right, fueling economic growth, increasing output and decreasing unemployment. The increase in price level along with all the other effects helps to fight recession.

Suppose the government issues bonds in period 0 in order to fund its increased government spending. Now, recessions tend to increase the risk aversion nature of consumers. Investors are most likely to sell off the riskier bonds and move onto more secured government treasury bonds. So, the prices of these bonds increase, the yield decrease. As the prices of the bonds go up, the interest rate, r falls. As the recession doesn't continue onto period 1, the income expectations do not remain the same. The income expectations may increase. Also, the lower interest rates make borrowing and investing much cheaper. So, it affects the consumers' purchasing power positively. Thus, aggregate consumption may increase further.