Consider a two-period endowment economy where there is one consumer. Our focus is the intertemporal consumption...

 

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Consider a two-period endowment economy where there is one consumer. Our focus is the intertemporal consumption decision of him. • Assume his current-period and future-period incomes are both y > 0, current and future (lump-sum) taxes are f₁ and t2, both of which are smaller than y, namely, t₁ < y and t₂ < y. • The consumer would like to maximize his/her life time utility: u = min{c₁, c2}. (That means optimally he/she will set C₁ = c2, if possible.) • However, this consumer is faced with a credit market friction. Suppose the consumer faces a positive saving interest rate r and a positive borrowing interest rate r' > r. In other words, for each yuan he saves today, he will obtain 1 + r yuan in the future period. For each yuan he borrows today, he will need to pay back 1 + r' yuan in the future period. Give answers for the following questions. a Suppose there is no credit market frictions (that is, r = r'), what is the optimal consumption bundle {ci,c}? (4 points) b Explain in one sentence the meaning of the following statement: "without credit market frictions, Ricardian equivalence holds". (2 points) c Now let's bring the financial frictions into analysis. Can you provide a micro-founded story for credit market frictions behind r'>r? (3 points) d Given that the credit market frictions exist, under what conditions will the consumer still choose {c₁, c₂} that you derived in question (1)? (4 points) e Suppose lump-sum taxes was the same t₁ = t₂ = t, and a reform on taxes would change to t₁ = t+At and t₂ = t-(1+r) At for some At > 0. Note the tax burden does not change due to the reform. What would be the consumer's new optimal consumption bundle {c₁, c₂"} under {₁,2}? (5 points) f Would Ricardian equivalence hold in this case? Would the consumer suffer or benefit from this reform? Explain your results. (2 points) Consider a two-period endowment economy where there is one consumer. Our focus is the intertemporal consumption decision of him. • Assume his current-period and future-period incomes are both y > 0, current and future (lump-sum) taxes are f₁ and t2, both of which are smaller than y, namely, t₁ < y and t₂ < y. • The consumer would like to maximize his/her life time utility: u = min{c₁, c2}. (That means optimally he/she will set C₁ = c2, if possible.) • However, this consumer is faced with a credit market friction. Suppose the consumer faces a positive saving interest rate r and a positive borrowing interest rate r' > r. In other words, for each yuan he saves today, he will obtain 1 + r yuan in the future period. For each yuan he borrows today, he will need to pay back 1 + r' yuan in the future period. Give answers for the following questions. a Suppose there is no credit market frictions (that is, r = r'), what is the optimal consumption bundle {ci,c}? (4 points) b Explain in one sentence the meaning of the following statement: "without credit market frictions, Ricardian equivalence holds". (2 points) c Now let's bring the financial frictions into analysis. Can you provide a micro-founded story for credit market frictions behind r'>r? (3 points) d Given that the credit market frictions exist, under what conditions will the consumer still choose {c₁, c₂} that you derived in question (1)? (4 points) e Suppose lump-sum taxes was the same t₁ = t₂ = t, and a reform on taxes would change to t₁ = t+At and t₂ = t-(1+r) At for some At > 0. Note the tax burden does not change due to the reform. What would be the consumer's new optimal consumption bundle {c₁, c₂"} under {₁,2}? (5 points) f Would Ricardian equivalence hold in this case? Would the consumer suffer or benefit from this reform? Explain your results. (2 points)

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a Suppose there is no credit market frictions that is r r what is the optimal consumption bundle cc 4 points The optimal consumption bundle for the co... View the full answer