In this problem, consider how the theory of rational expectations will affect the predicted response to a government's attempt to boost the economy by giving citizens cash. For this problem, suppose that people have rational expectations and are not credit constrained (that is, individuals can lend and borrow freely at an interest rate of 4%). The government gives each citizen $5,000 with the intention of repaying the debt incurred by doing so via future taxation (since people have rational expectations, everyone knows this). The government faces an interest rate that may be the same as or different than that faced by itscitizens.

If people behave in the manner postulated in the theories of rational expectations and the permanent income hypothesis, what do people see as happening to the present value of their lifetime income, and how does overall spending change when the government faces the interestrates?

Interest rate faced by Spending today Lifetime income

5%

3%

4%

Remain the same Increase Decrease