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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 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 𝐶 is consumption, 𝑇 is taxation, 𝐺 is government expenditure, and 𝑟 is the real interest rate. Subscripts denote periods 1 and 2.
Are You Looking for Answer of This Assignment or Essay
You may assume that household and government face the same real interest rate, 𝑟. 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 𝐶1 = (𝑌1 − 𝑇1) and 𝐶2 = (𝑌2 − 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 𝑇1′ in period 1 and consequently increases taxes to 𝑇2′ 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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