Ricardian Equivalence Consider a consumer who receives incomes Y1 and Y2 in period 1 and 2 respectively. Imagine that there is a government who levies a tax on this individual. The total taxes paid in period 1 and 2 are T1 and T2 respectively. The individual has access to banks so he can borrow and lend any amount he desires at the interest rate r. Imagine that the amount of bonds he inherits when he start is zero (B0 = 0) and he want to leave no assets when he dies after period 2 (B2 = 0). The individual needs to choose the amount of consumption in period 1 and 2 (C1 and C2, respectively) that maximizes his utility subject to a budget constraint.

(a) Write the dynamic budget constraint (DBC) for period 1 and 2. (Note: Keep in mind that part of his expenditure are now taxes).

(b) Write the intertemporal budget constraint (IBC). Provide an interpretation. (c) Draw the budget constraint in a diagram that has C1 and C2 in the axes.

(d) Imagine that the individual likes to smooth consumption. How would his indierence curves look like? Why?

(e) Display his optimal choice given the after-tax endowment, where he becomes a borrower at period 1.

(f) Suppose that the government decreases the tax rates in period 1, T1, and in period 2, T2, both by the same amount (i.e. 4T1 = 4T2 = 4T

(g) Suppose that the government decreases the tax rates in period 1, T1, and T2 remains the same (i.e. 4T1

(h) Suppose that the government decreases the tax rates in period 1, T2, and keeps T1 (i.e. 4T1 = 0, 4T2

(i) Imagine that the government decreases T1 by 4T 0. Would his consumption in period 1 change? By how much?

3 Ricardian Equivalence Consider a consumer who receives incomes Y, and 12 in period 1 and 2 respectively. Imagine that there is a government who levies a tax on this individual. The total taxes paid in period 1 and 2 are 71 and 72 respectively. The individual has access to banks so he can borrow and lend any amount he desires at the interest rate r. Imagine that the amount of bonds he inherits when he start is zero (Bo = 0) and he want to leave no assets when he dies after period 2 (By = 0). The individual needs to choose the amount of consumption in period 1 and 2 (C1 and C2, respectively ) that maximizes his utility subject to a budget constraint. (a) Write the dynamic budget constraint (DBC) for period 1 and 2. (Note: Keep in mind that part of his expenditure are now taxes). (b) Write the intertemporal budget constraint (IBC). Provide an interpretation. (c) Draw the budget constraint in a diagram that has C and Cy in the axes. (d) Imagine that the individual likes to smooth consumption. How would his indifference curves look like? Why? (e) Display his optimal choice given the after-tax endowment, where he becomes a borrower at period 1. (f) Suppose that the government decreases the tax rates in period 1, 71, and in period 2, 72, both by the same amount (ie. AT1 = AT2 = AT 0. Would his consumption in period 1 change? By how much