PART B: The Lannisters send their regards The Lannisters are in power in King's Landing. The...

 

Transcribed Image Text:

PART B: The Lannisters send their regards The Lannisters are in power in King's Landing. The people of King's Landing live for two periods. They have some income y = y' = in both periods. They can consume (c) or save/borrow (s) in the first period. They can consume (c) in the second period. For the moment assume that taxes (and government spending) are zero in both periods. In the credit markets, the real interest rate is r. In King's Landing consumers have special intertemporal preferences: they think consumption in the current and future period are perfect complements. Hence, their indifference curves look like an L, with the corner in c c' (see diagram). e. d. What would be the optimal choice of a consumer? Write down the intertemporal budget constraint. Find the optimal choice. Explain your reasoning and illustrate it with a diagram. (Slow and Dumb) The Lannisters need funding for the war with the King in the North. This implies that government spending increases in the first period: G > 0 and G' = 0. The Lannisters are worried about an insurrection, hence they plan to increase taxes in the second period to F, while keeping them equal to zero in the first period. Show with a diagram, and explain, how the consumer's problem changes, and what would be the optimal choice after the future tax increase is announced. (Slow and Dumb) f. After the new taxes are announced, there is an increase of the real interest rate (from r to f). Hence not only future taxes are now positive as in (e), but the interest rate is also higher. Explain how the optimal choice of the consumer changes with respect to (e). Illustrate with a diagram how the income and substitution effect affect the intertemporal allocation of consumption. (Fast and Dumb) PART B: The Lannisters send their regards The Lannisters are in power in King's Landing. The people of King's Landing live for two periods. They have some income y = y' = in both periods. They can consume (c) or save/borrow (s) in the first period. They can consume (c) in the second period. For the moment assume that taxes (and government spending) are zero in both periods. In the credit markets, the real interest rate is r. In King's Landing consumers have special intertemporal preferences: they think consumption in the current and future period are perfect complements. Hence, their indifference curves look like an L, with the corner in c c' (see diagram). e. d. What would be the optimal choice of a consumer? Write down the intertemporal budget constraint. Find the optimal choice. Explain your reasoning and illustrate it with a diagram. (Slow and Dumb) The Lannisters need funding for the war with the King in the North. This implies that government spending increases in the first period: G > 0 and G' = 0. The Lannisters are worried about an insurrection, hence they plan to increase taxes in the second period to F, while keeping them equal to zero in the first period. Show with a diagram, and explain, how the consumer's problem changes, and what would be the optimal choice after the future tax increase is announced. (Slow and Dumb) f. After the new taxes are announced, there is an increase of the real interest rate (from r to f). Hence not only future taxes are now positive as in (e), but the interest rate is also higher. Explain how the optimal choice of the consumer changes with respect to (e). Illustrate with a diagram how the income and substitution effect affect the intertemporal allocation of consumption. (Fast and Dumb)