Consumption Theory Question

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    15-Dec-2015

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consumption theory

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Suppose that the NZ Parliament passes a law to permanently cut/raise taxes starting the next year. Assuming that consumers do not follow Ricardian equivalence, when would consumers adjust their spending according to the:1. Keynesian consumption functionCurrent consumption depends only on current income, so next year.Current consumption depends only on current income, so next year.2. Fisher two-period model with binding borrowing constraintsUsually immediately but as binding borrowing constraints, next year.Decrease immediately3. Random-walk hypothesis with no permanent binding borrowing constraintImmediately. Only unanticipated changes in income or wealth that alter expected permanent income will change consumption. Decrease immediatelyHow would answers change if consumers follow Ricardian equivalence?1. Would not change will save the tax cut.2. Same binding constraints mean they may spend the tax cut (if below optimal consumption).3. Consumption would not change they will save the tax cut.

How do binding borrowing constraints change the determination of current consumption in the Fisher two-period model and in the random walk hypothesis? In the Fisher model, if consumer faces borrowing constraints (a.k.a. liquidity constraints), then she may not be able to increase current consumption and her consumption may behave as in the Keynesian theory even though she is rational & forward-looking. In the random-walk hypothesis, expected permanent income has increase may try to increase current spending, but cant. Changes in fiscal policy do influence consumer spending if they influence present or future government purchases. For example, suppose that the government cuts taxes today because it plans to reduce government purchases in the future. If the consumer understands that this tax cut does not require an increase in future taxes, he feels richer and raises his consumption. But note that it is the reduction in government purchases, rather than the reduction in taxes, that stimulates consumption: the announcement of a future reduction in government purchases would raise consumption today even if current taxes were unchanged because it would imply lower taxes at some time in the future.