Chapter 9

Question 1

What dual role does the government play in the economy?

Answer 1

The government engages in direct lending to the private sector and issues debt to private economic agents, acting as both a lender and a borrower.

Question 2

What is the government’s present-value budget constraint?

Answer 2

The government must eventually pay off all of its debt by taxing its citizens.

Question 3

What are the three conditions for competitive equilibrium in a two-period economy?

Answer 3

• Each consumer chooses first- and second-period consumption and savings optimally given the real interest rate r.
• The government present-value budget constraint holds.
• The credit market clears.

Question 4

What does credit market equilibrium imply?

Answer 4

The income-expenditure identity holds.

Question 5

What is the income-expenditure identity formula?

Answer 5

Y - C - T = G - T

Question 6

What does the Ricardian Equivalence theorem state?

Answer 6

A change in the timing of taxes by the government is neutral.

Question 7

What is the key equation related to the consumer’s lifetime tax burden?

Answer 7

The consumer’s lifetime tax burden is equal to the consumer’s share of the present value of government spending.

Question 8

Fill in the blank: The consumer’s budget constraint shows that taxes do not matter in equilibrium for the consumer’s _______.

Answer 8

lifetime wealth

Question 9

What happens when there is a cut in current taxes according to Ricardian Equivalence?

Answer 9

The government must issue more debt today and increase taxes in the future to pay off this higher debt.

Question 10

How do consumers respond to a tax cut in terms of their savings?

Answer 10

Consumers increase their savings by the amount of the tax cut.

Question 11

What is the effect of increased consumer savings on the credit market when taxes are cut?

Answer 11

There is no effect on borrowing and lending among consumers or on the market real interest rate.

Question 12

What happens to the consumer’s optimal consumption bundle when current taxes are cut?

Answer 12

The consumer’s optimal consumption bundle remains unchanged.

Question 13

What might cause Ricardian Equivalence to fail in practice?

Answer 13

• Redistributional effects of taxes.
• Intergenerational redistribution.
• Taxes are not lump sum and cause distortions.
• Credit market frictions.