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

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

UniversityUniversity of East Anglia (UEA)
SubjectECO-5007B: Intermediate Macroeconomics Assignment

Question 1 [10 marks]

Consider a two-period economy with a household and government.

The household behaves according to its intertemporal budget constraint, but faces a borrowing constraint that prevents period-1 consumption from exceeding period-1 disposable income, which can be written as follows,

Here ๐ถ is consumption, ๐‘‡ is taxation, ๐บ is government expenditure, and ๐‘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, ๐‘Ÿ. Further, suppose that the household has a preference for consumption today, such that its borrowing constraint is binding, forcing it to consume its period-1 income today and period-2 income tomorrow. That is to say, initially ๐ถ1 = (๐‘Œ1 ๐‘‡1) and ๐ถ2 = (๐‘Œ2 ๐‘‡2).

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 ๐บ1 and ๐บ2, but it cuts taxes to ๐‘‡1 in period 1 and consequently increases taxes to ๐‘‡2 in period 2, to still obey its intertemporal budget constraint.

Is the fiscal policy via the tax cut effective at stimulating period-1 consumption? Draw a diagram and provide clear explanation about how this example relates to Ricardian Equivalence.
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