Assume the two-period Fisher model, where the government and the household both
ID: 1211411 • Letter: A
Question
Assume the two-period Fisher model, where the government and the household both have to abide by two-period budget constraints, and where there is no investment expenditure. Suppose you have the following information: ????Consumption (C) Income (Y) Taxes (T) Period 1 100 145 65 Period 2 100 145 20 [Hint: the consumer’s budget constraint with taxes (T) is: C2= (Y2 –T2)+(1+r)(Y1 –T1-C1)] a) Compute what the interest rate must be. b) Present a graph for the two-period model and clearly label: i) the vertical and horizontal intercepts with numerical values; ii) the value for disposable income in each period; and iii) the point of consumer equilibrium with the numerical value for C in each period. c) Suppose, in order to stimulate the economy in period 1, the government cuts taxes in period 1 to 0 (T falls from 65 to 0) with no change in government spending in either period. What is the effect on consumption in period 1? [Hint: I am looking for a numerical solution with a discussion of the impact on consumption. Also, remember that the government has a two-period budget constraint. So holding G constant means T2 must increase if T1 decreases. You must determine the increase in T2.]
Explanation / Answer
Answer a) Given that
C2= (Y2 –T2)+(1+r)(Y1 –T1-C1)]
putting values we get,
100=(145-20)+(1+r)(145-65-100)
100-125=(1+r)* -20
-25=-20 (1+r)
1.25=1+r
r=0.25
answer b)
disposable income
period 1=145-65=80
period 2=145-20=125
answer c)since if government cuts taxes in period 1 to zero,the disposable income will increase ,it will be now=145-0=145
According to ricardian theory,the timing of taxes has no influence on consumption it just changes one thing that is savings.
Since the current tax cut is transitory,it will lead to budget deficits in near future that is in period 2. So to cover the deficits government will borrow & increase taxes. The result is a movement of the endowment point along the budget constarint with no corresponding change in consumption.
new taxes in period2=20+change in taxes
=20+65