Exercise 14.2 (An Economy with Lump-Sum Taxes) Consider a two- period endowment economy. Assume that households' preferences are described by the following utility function

(sqrtC1)+[1/1.1(sqrtC2)], where C1 and C2 denote consumption in periods 1 and 2, respectively. In each period, households are endowed with 10 units of goods. Also, households pay lump-sum taxes T1 and T2, in periods 1 and 2, respectively. Finally, households are born with no financial assets (B0p = 0) and can borrow or lend in the international financial market at the world interest rate r = 0.1. The government starts period 1 with no outstanding assets or liabilities (B0g = 0). In period 1, the government collects lump-sum taxes T1 and consumes G1 = 1 units of goods. In period 2, it collects lump-sum taxes T2 and consumes G2 = 1 units of goods. Like the household, the government has access to the world financial markets.

1. Compute the equilibrium levels of consumption, the trade balance, and the current account in periods 1 and 2.
2. Suppose that T1 = 0. What is T2? What is private, public, and national saving in periods 1 and 2?
3. Suppose now that T1 increases from 0 to 1 while government purchases are unchanged in both periods. How does this tax hike affect the current account and the fiscal deficit in period 1? Briefly explain your result.
4. Suppose that in period 1 the government increases spending from 1 to 2 and keeps government spending in period 2 unchanged. What is the effect of this policy change on the current account in period 1? Explain.
5. Finally, suppose that there is a permanent increase in government purchases: both G1 and G2 increase by 1 unit. What is the response of the current account in period 1? Compare your result with that from the previous question and provide intuition.