dynamic model

Question 1

endowment economy

Answer 1

no production

Question 2

types of agents/sectors (2)

Answer 2

1. consumers
2. government

Question 3

describe two-period economy

Answer 3

1. consumers’ choice between current & future consumption via saving
2. the government’s choice between current and future taxes

Question 4

exogenous income variables (2)

Answer 4

1. y: consumer’s real income in current period
2. y’: consumer’s real income in future period

Question 5

tax variables (2)

Answer 5

1. t: lump-sum taxes in current period
2. t’: lump-sum taxes in future period

Question 6

consumption variables (2)

Answer 6

1. c: current consumption
2. c’: future consumption

Question 7

formula for what consumer saves in current period

Answer 7

s = y - t - c

Question 8

if y - t > c…?

Answer 8

consumer saves (is a lender); s > 0

Question 9

if y - t < c…?

Answer 9

consumer borrows; s < 0

Question 10

equation for budget constraint

Answer 10

c + s = y − t

Question 11

lending & borrowing is done by…?

Answer 11

issuing bonds

Question 12

a bond issued today pays…?

Answer 12

(1+r) units of consumption in the future

Question 13

consumer’s future-period budget constraint

Answer 13

c’ = y’ − t’ + (1+r)s

Question 14

lifetime budget constraint

Answer 14

c + c’/(1+r) = y - t + (y’ - t’)/(1 + r)

Question 15

lifetime wealth

Answer 15

we = y - t + (y’ - t’)/(1 + r)

Question 16

utility function (U(c, c’))

Answer 16

captures consumer preferences over c and c’

Question 17

properties of consumer’s preferences (3)

Answer 17

1. more is always preferred to less
2. the consumer likes diversity in his or her consumption bundle
3. current and future consumption are normal goods

Question 18

an increase in consumer’s current income causes…? (4)

Answer 18

1. lifetime wealth increases
2. parallel shift of BC to the right
3. current & future consumption increase
4. savings increases

Question 19

aggregate consumption of non-durables and services

Answer 19

smooth relative to aggregate income

Question 20

aggregate consumption of durables

Answer 20

more volatile than income because durables consumption is economically more like investment than consumption

Question 21

an increase in consumer’s future income causes…? (4)

Answer 21

1. lifetime wealth increases
2. parallel shift of BC to the right
3. current & future consumption increase
4. savings decreases

Question 22

permanent increase in consumer’s income causes…? (3)

Answer 22

1. lifetime wealth increases
2. horizontal increase in BC in current period; vertical increase in BC in future period
3. current consumption increase

Question 23

temporary increase in consumer’s income causes…?

Answer 23

consumer will tend to save most of a purely temporary income increase

Question 24

increase in the real interest rate causes…?

Answer 24

1. affected tradeoff between current & future consumption
2. steeper BC line

Question 25

how does an increase in the real interest rate affect a borrower? (2)

Answer 25

1. current consumption decreases
2. savings increases

Question 26

how does an increase in the real interest rate affect a lender?

Answer 26

1. future consumption increases

Question 27

assumption about government consumption

Answer 27

government purchases G consumption goods in the current period and G′ in the future (exogenous)

Question 28

variables w/ government shi (4)

Answer 28

1. G: government expenditures in current period
2. N: consumers who pay current taxes
3. T: total taxes collected in the current period
4. B: the quantity of government bonds issued in the current period

Question 29

government’s CURRENT period budget constraint

Answer 29

G = T + B

Question 30

describe government’s CURRENT period budget constraint

Answer 30

government spending financed w/ taxes and issuance of bonds

Question 31

government’s FUTURE budget constraint

Answer 31

G′ + (1 + r)B = T’

Question 32

describe government’s FUTURE period budget constraint

Answer 32

future government spending & the principal and interest on the government bonds issued in the current period are financed through future taxes

Question 33

present value of government purchases must equal…?

Answer 33

the present value of taxes

Question 34

what happens in competitive equilibrium? (3)

Answer 34

1. each consumer optimizes given the budget constraint
2. government’s present value budget constraint hold
3. credit market clears (S = B)

Question 35

(credit market equilibrium) aggregate quantity of private savings is equal to…?

Answer 35

quantity of debt issued by the government in the current period

Question 36

ricardian equivalence theorem

Answer 36

government deficit spending is counter balanced by increased private saving, as individuals anticipate future tax hikes to repay the debt

Question 37

effect of ricardian equivalence theory

Answer 37

1. lifetime wealth (we) remains unchanged, as the PV of taxes has not changed
2. budget constraint is unaffected

Question 38

why might ricardian equivalence fail in practice? (4)

Answer 38

1. tax changes affect the wealth of different consumers differently
2. the government can postpone the taxes required to pay off the debt
3. all taxes are distortionary (based on individual actions)
4. consumers face constraints on how much they can borrow

Question 39

assumptions of ricardian equivalence (4)

Answer 39

1. taxes change by the same amount for all consumers
2. any debt issued by government is paid off during lifetimes of people alive when debt was issued
3. taxes are lump sum
4. perfect credit markets

Question 40

discount factor

Answer 40

rate at which the consumer
discounts future consumption