31410fps5sol - Economics 314-1 Problem Set 5 Suggested...

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Economics 314-1 Fall 2010 Problem Set 5 Suggested Solutions Question 1: (Chapter 16, Question 4) A rule requiring a cyclically adjusted balanced budget has the potential to overcome, at least partially, the first two objections to a balanced-budget rule that were raised in this chapter. First, this rule allows the government to run countercyclical fiscal policy in order to stabilize the economy. That is, the government can run deficits during recessions, when taxes automatically fall and expenditures automatically rise. These automatic stabilizers affect the deficit but not the cyclically adjusted deficit. Second, this rule allows the government to smooth tax rates across years when income is especially low or high-it is not necessary to raise tax rates in a recession or to cut them in booms. On the other hand, this rule only partially overcomes these two objections, since the government can only run a deficit of a certain size, which might not be big enough. Also, a cyclically adjusted balanced budget does not allow the government to smooth tax rates across years when expenditure is especially high or low, as in times of war or peace. (We might take account of this by allowing an exemption from the balanced budget rule in special circumstances such as war.) This rule does not allow the government to overcome the third objection raised in the chapter, since the government cannot shift the burden of expenditure from one generation to another when this is warranted. Finally, a serious problem with a rule requiring a balanced cyclically adjusted budget is that we do not actually observe this budget. That is we need to estimate how far we are from full employment; then we need to estimate how expenditures and taxes differ if we were at this full-employment level. None of these estimates can be made precisely. Question 2 a. We can use Jill’s intertemporal budget constraint to solve for the interest rate: C 1 + C 2 /(1 + r) = Y 1 + Y 2 /(1 + r) $100 + $100/(1 + r) = $0 + $205/(1 + r) r = 5%. Jill borrowed $100 for consumption in the first period and in the second period used her $205 income to pay $105 on the loan (principal plus interest) and $100 for consumption. b.
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31410fps5sol - Economics 314-1 Problem Set 5 Suggested...

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