ECON5102 Consumption, Fiscal Policy
Consumption, Fiscal Policy
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ECON5102 Assignment 3: Consumption, Fiscal Policy and International Trade Term 3
Due date 15th of November at 9.00am. Electronic submission through Moodle.
Please include a complete and signed cover sheet (available on Moodle).
Not all the questions in this Assignment will be marked (please see details in the Course Outline)
We will mark Part A, section b) and Part B, section a).
You are free to type or handwrite your solutions. If you prefer to type them, make sure to use Microsoft Word equations (or equivalent) to write down your equations properly, otherwise reserve a space to handwrite them. If you prefer to handwrite the whole assignment or parts of it, make sure the handwriting is clear, well-organised and legible.
Please read the questions carefully and go straight to the point.
Please submit a single pdf file (including the cover sheet).
Part A: Consumption
Suppose that a household has a utility function and intertemporal budget constraint as
follows:
ሺଵ, ଶሻ ൌ ሺଵ.ହ ଶ.ହሻଵିఊ1 െ
ITBC: ଵ మଵା ൌ ଵ
௬మ
ଵା
a) Determine the marginal rate of substitution for this utility function and derive the Euler
equation faced by this consumer (define the Lagrangian and then obtain first order conditions
as we did it in the lecture). Explain the intuition of the Euler equation.
b) Find a solution for optimal consumption in both period 1 and 2 as a function of the
parameter as well as the variables r, ଵ and ଶ.
c) What is the ceteris paribus effect on consumption today (ଵ) and tomorrow (ଶ) of the
following shocks:
(i) An increase in .
(ii) A decrease in lifetime income.
(iii) An increase in .
d) Is there a condition where ଵ= ଶ? If so, what value must β assume?
Part B: Fiscal Policy
Consider an economy existing for four periods following the government budget constraint as
follows:
௧ାଵ ൌ ሺ1 ሻ௧ ௧ െ ௧
a) Define each of the variables above and explain, in words, why the equality holds. Re-write
this budget constraint during each of the four periods that the economy exists.
b) The Australian government is trying to decrease the country’s stock of debt. Using the
equation above, discuss two possible ways this could be achieved using fiscal policy, only.
What challenges do you anticipate? (Hint: think of how tax collections change given changes
to government spending).
c) Using the elements in the equation above, discuss the likely effects on the future stock of
debt (௧ାଵ) of an expansionary monetary policy. Explain.
d) What will the equation look like in the fourth period and what does this imply for the
economy as a whole?
e) Using backwards iteration from the fourth period, form and interpret (in at least two
sentences) the intertemporal government budget constraint for this economy.
Part C: International Trade
Solve exercise 4, chapter 19 (Jones 4th Ed, pp 544 - Jones 5th Ed, pp 556).