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Unformatted text preview: you lend
and a HIGHER one that you pay when you borrow. This is the way it is in the real world.
Suppose that a consumer would like to borrow to increase present consumption.
However, for some reason – maybe a poor credit rating – they cannot find financing at
the borrowing rate of interest.
This is what we mean by a credit constrained consumer.
Now suppose this type of consumer gets a tax cut from the government. This tax cut is a
substitute for the at least some of the funds they wanted to borrow to increase present
consumption. In fact, it is like an interest free loan!! If there are a lot of credit constrained
consumers in an economy then a current period tax cut may increase current
You should follow this argument using the diagram below. This is the only analytical
argument we are giving for failure of Ricardian equivalence the consumer will consume the entire tax cut....
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- Fall '10