Consider a two-period model of a closed economy with government. Assume that the representative agent is...

Consider a two-period model of a closed economy with government. Assume that the representative agent is endowed with ?1 and ?2 as initial endowments in period 1 and period 2 respectively, and has the utility function ? = ln ?1 + ? ln ?2, where ?1 and ?2 denote consumption and ? is the discount rate. Suppose that the government spends ?1 and ?2 in period 1 and period 2 and finances its expenditure through lump-sum taxes ?1and ?2 in periods 1 and 2 respectively.

(i) Derive the inter-temporal budget constraints of the representative agent and the government. [5]

(ii) Suppose if government borrows ? units at the interest rate of ? to finance its expenditure in period 1, derive the amount of taxes that would satisfy its inter-temporal budget constraint. Explain whether Ricardian Equivalence holds in this situation. [15]

Expert Solution

Rahul Sunny answered 6 months ago

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