q2

Question 2 (12 marks) (a) (b) (C) (d) (6) Consider a two period model of the economy and assume the interest rate is i = 10%. Write down and interpret the government's intertemporal budget constraint. Be sure to define all the variables. The government decides to increase government spending on infrastructure by $100 million in period 1 (Le. today) and to leave government spending in period 2 unchanged. It finances the increase in government spending by selling bonds today. Show what future action the government will need to do if it is to satisfy its intertemporal budget constraint. Suppose consumers behave according to the permanent income/life cycle hypothesis. Given your answer in part (b), what must happen to private saving, government saving, total saving and investment in period 1? (Assume foreign saving does not change). Justify your answer. Suppose a government has an initial debt of $500 million and keeps its primary budget in balance. The nominal interest rate is 3% per year and the economy grows at 2% each year. What is the growth rate of the government debt to GDP ratio? Explain your answer fully. How would your answer in part (d) change if the government keeps its total budget in balance? Explain your answer fully