Consider an economy in which consumers have identical preference and income. The
ID: 1220140 • Letter: C
Question
Consider an economy in which consumers have identical preference and income. The income is determined randomly and exogenously in each period. Consumers prefer smooth consumption over time. Production does not involve capital so that there is no investment. The government balances its budget each period by collecting a lump-sum tax to finance an exogenous amount of government purchases. Suppose this is a close economy. Will consumption be less volatile than income in the competitive equilibrium? Explain. Suppose this is a small open economy facing exogenously given price and interest rate in the international market. Will consumption be less volatile than income in the competitive equilibrium? Explain.
Explanation / Answer
In close economy, consumption will be more volatile than income in competitive equilibrium because there is no investment as well as tax is lump-sum. In small open economy, income will be more volatile because of effect of price and interest rate in the international market.