Tutorial 9
ECON2102 - Macroeconomics II
Fiscal Policy
1. Consider an economy that exists for 3 periods: period 1, period 2 and period 3. In each case the government must satisfy the budget constraint:
Bt+1 = (1 + i)Bt + Gt - Tt
a) Write this budget constraint for each period.
b) What must be true for B4?
c) Using the results from part (b), solve the period 3 budget constraint for B3 and substitute this back into the period 2 constraint.
d) Solve this new version of the period 2 budget constraint for B2 and substitute the result back into the period 1 budget constraint.
e) You should have the intertemporal budget constraint for the three-period economy. Interpret this equation.
2. Suppose a government has an initial debt of $10 billion and the nominal interest rate is 5 percent.
a) If the government keeps its primary budget in balance, what is the growth rate of its debt?
b) If the government keeps its total budget in balance, what is the growth rate of its debt?
c) Suppose the country’s GDP grows at 3 percent per year. What happens to the debt-GDP ratio over time in cases (a) and (b)? Are these situations sustainable? Explain.
3. Suppose that a household’s utility function is given by:
u(c, e) + v(g)
and its budget constraint by: c = w(1 - e) + d - τ where τ is tax.
Use a diagram to show the solution cD, eD, ns to the above problem. (Assume d = 0 for simplicity; of course, in general equilibrium, it will be zero.) Indicate how ns is predicted to respond to an increase in τ.
4. Explain, using the household and government budget constraint, what is meant by Ricardian Equivalence.
5.* Consider an exogenous decrease in government spending that is also matched by a decrease in taxes. What are the predictions for consumption, output, employment, and household welfare (utility) in the frictionless equilibrium model of fiscal policy (neo-classical model)?