Question

4, (2 p.) Imagine a world of only two periods and zero interest rates. A consumer's income is 60 in period 1 and 80 in period 2, taxes are 20 in each period, permanent disposable income is therefore 50, and consumption is 50 per period (since the world ends after period 2). The government now offers a tax cut of 10 in period 1, financed by government borrowing that will be repaid in period 2 (a) What is disposable income now in each period for the consumer? What is permanent disposable income? What is the effect on consumption decisions? (b) If the government pays zero interest on loans, but the consumer pays 10 per cent interest, what is now the effect of the temporary tax cut?

Answer 1

(a) Govt borrows 10 in period 1 and will repay the same in Period 2. This enables the consumer to consume uniformly in both periods (i.e. 50 in each), otherwise he would have ad to borrow 10 in 1st period to attain the consumption of 50! Permanent Disposable income is 50.

	Period 1	Period 2
Income	60	80
Taxes	20	20
Disposable Income	40	60
Consumption	50	50
New tax	10	30
Disposable Income Now	50	50

(b) If Government pays Zero Interest, disposable income and the consumption is 50 in each period.

But, if consumer borrows as 10%, he will have to borrow 10 today to attain his consumption of 50, and would have to repay 11 in the second period. Hence, his disposable income becomes: 80- 20- 11 = 49, hence his consumption reduces by 1, which he pays as interest!