Question

1. In each of the following cases, identify whether the problem is adverse selection or moral hazard, and explain your answer. How might the problem be dealt with?

1. The IMF has given a large payment to the nation of North Dystopia to help them cope with a financial crisis. With the money in hand, the government prefers spending the money on erecting statues in honor of their esteemed leader rather than on economic policies to improve their financial system.
2. The nation of South Dystopia is trying to get a large loan from the World Bank. The government knows, but the World Bank does not, that the country is very unstable and there could be a military coup in the next year.
3. The US commercial banking system, whose deposits are protected by the FDIC (Federal Deposit Insurance Corporation), begins to invest in high risk/high return collateralized debt instruments (e.g. derivatives) rather than making traditional loans.

2. According to the traditional view of government debt, how does a debt-financed tax cut affect public savings, private savings, and national savings? How does the Ricardian view differ from the traditional view for each of these categories of savings? Do you find the traditional or Ricardian view of government debt more credible? Explain your rationale

Answer 1

1) a) First one is the case of moral hazard where North Dystopia chooses to spend their money on erecting statues rather than on economic policies.

b) This is the case of adverse selection where World Bank does not know about South Dystopia and about military coup in the next year.

c) It is a case of Moral hazard where US commercial banking system invest in high risk collaterized debts instruments.

2) Tax cut stimulates consumer spending and increases national saving. It creates an expansionary shift in IS curve. The immediate impact of the tax may stimulate consumer spending and it affects the economy in both the short-run and the long-run. In the short-run, higher consumer spending would raise the demand for goods and services and raise output and employment

According to Ricardian, consumers are forward-looking and consumption does not depend upon their current income.

The consumer may think that if government deduct the taxes so their permanent income will bot be increased. The government is financing the tax cut by running a budget deficit, the government will have to raise taxes to pay-­off the debt and accumulated interest.

So the policy rmeans a tax cut today with a tax hike in the future.

Ricardian theory has more credible because theory states about forward looking consumers who are well aware about government tax cut policy