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Problem Set 6
Suggested Solutions
1.1
(1)
(2)
Notice that government is forced to issue debt since there are no revenues
from taxation in the first period. The intertemporal budget constraint is:
g2
sr2
g1 +
=
(3)
1+r
1+r
Equation 3 tells us that the present value of government expenditure must
be equal to the present value of government revenues from taxation.
1.2
Households problem
max u(c1 , c2 ) = ln c1 + ln c2
(4)
c1 + s = y1
(5)
subject to:
c2 = (1 + (1 2 )r)s + y2
(6)
c2
(1 + (1 2 )r)
= y1 +
y2
(1 + (1 2 )r)
(7)
You can easily write down the lagrangean for this problem and get the
following Euler equation:
c2 = (1 + (1 2 )r)c1
The Euler equation depends on taxation.
1
(8)
1.3
Ricardian Equivalence
In this economy there is no room for fiscal policy in the sense that the
government cannot choose between debt and taxation to finance its expenditure. This is due to the fact that at time 1 the government can only use
debt. The Ricardian Equivalence does not hold in this economy since the
taxation is not lump-sum.
2.1
c2
w2 (1 2 )(1 l2 )
= w1 (1 1 )(1 l1 ) +
1+r
1+r
(9)
w2 2 (1 l2 )
g2
= w1 1 (1 l1 ) +
1+r
1+r
(10)
2.2
w2 (1 l2 )
w2 2 (1 l2 )
w1 1 (1 l1 )
1+r
1+r
w2 (1 l2 )
g2
= w1 (1 l1 ) +
g1
1+r
1+r
c2
1+r
= w1 (1 l1 ) +
Households problem
(11)
w2 (1 2 )(1 l2 )
c2
= w1 (1 1 )(1 l1 ) +
1+r
1+r
(12)
subject to:
c1 +
(13)
c2 : /c2 = /(1 + r)
(14)
l1 : /l1 = w1 (1 1 )
(15)
w2 (1 2 )
(16)
1+r
The Euler equation can be obtained by combining equations (13) and (14):
l2 : /l2 =
c2 = (1 + r)c1
(17)
l1
w2 (1 2 )
=
l2
w1 (1 1 )(1 + r)
(18)
2.3
(19)
Competiteve Equilibrium
2.4
Ricardian Equivalence
In this case Ricardian Equivalence does not hold since government is not
using lump sum taxation. The Euler equation does not depend on taxes,
but this is not sufficient for the Ricardian equivalence to hold. You can use
a more sophisticated argument to show that the equivalence does not hold
by playing with the intertemporal budget constraint.
From the households FOC we can recover that at the optimum:
l1 =
l2 =
c1
(1 1 )w1
c2
(1 2 )w2
c2
c1 +
1+r
= w1 1
w2 1 c2
c1
g2
(12 )w2
+
g1
(1 1 )w1
1+r
1+r