Case Study: A Government Stimulus and Its Intertemporal Effects

Background Scenario:

Imagine a small open economy, Wakanda, that experiences a one$-$time government stimulus.

The government announces an infrastructure development program, leading to a significant

increase in current output $($Y$1),$ but with no expected increase in future output $($Y$2).$ Households

in Wakanda have the option to save part of their income in domestic banks, which offer a real

interest rate $($r$)$ on savings.

The government hopes the stimulus will lead to an increase in present consumption $($C$1),$

boosting the economy. However, policymakers are concerned about the long$-$term impacts on

savings $($S$),$ future consumption $($C$2),$ and overall economic stability.

Using the framework of intertemporal trade and consumption demand, analyze the following:

Question:

a$)$ Explain how the increase in current output $($Y$1)$ affects present consumption $($C$1)$ and

savings $($S$),$ assuming future output $($Y$2)$ remains unchanged.

b$)$ Discuss the impact of a decrease in the real interest rate $($r$)$ on present and future

consumption $($C$1$ and C$2)$ for Wakanda, considering both income and substitution effects.

c$)$ Based on this analysis, evaluate how the intertemporal consumption framework can help

Wakanda$$s government design fiscal policies that balance present and future consumption,

saving, and growth