Consider a 2-period economy populated with consumers that have the same income and the same preferences. There is also a government whose objective is to spend 60 in period 0 and 150 in period 1. This government can issue bonds in period 0. Each bond pays an interest rate r. Consumers can also issue bonds at the same interest rate. Consumers' optimal decisions, given r, imply that aggregate consumption C0* is equal to 2/3(Yo – To) + 2/3(Y1 – T1)/(1+r). Suppose that Yo = 300 and that income is expected to remain at this level in period 1. A major recession begins in period 0. As a result, economic activity falls by 18 in period 0. National income is expected to fall by 20 in period 1. Consumers believe these economists. a) Use a graph to explain why the equilibrium interest rate r falls from 0.25 to 0.2 in period 0 because of this recession. c) Economists were wrong. The recession does not continue into period 1 so that y1 remains at 300. How does this new information affect consumers? Explain.
Consider a 2-period economy populated with consumers that have the same income and the same preferences. There is also a government whose objective is to spend 60 in period 0 and 150 in period 1. This government can issue bonds in period 0. Each bond pays an interest rate r. Consumers can also issue bonds at the same interest rate. Consumers' optimal decisions, given r, imply that aggregate consumption C0* is equal to 2/3(Yo – To) + 2/3(Y1 – T1)/(1+r). Suppose that Yo = 300 and that income is expected to remain at this level in period 1.
A major recession begins in period 0. As a result, economic activity falls by 18 in period 0.
a) Use a graph to explain why the equilibrium interest rate r falls from 0.25 to 0.2 in period 0 because of this recession.
c) Economists were wrong. The recession does not continue into period 1 so that y1 remains at 300. How does this new information affect consumers? Explain.
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