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chapter09_sol.pdf

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Department
Economics
Course
ECON 2450
Professor
All Professors
Semester
Fall

Description
CHAPTER 9 A TwoPeriod Model The ConsumptionSavings Decision and Credit MarketsKEY IDEAS IN THIS CHAPTER1 Consumption smoothing yields the results that a An increase in current income increases current saving as well as both current and future consumption b An increase in future income increases both current and future consumption but reduces current saving c A permanent increase in income has a larger impact on current consumption than a temporary increase in income d The effect of an increase in the real interest rate on current consumption depends on the relative strength of the income and substitution effects2 The Ricardian equivalence theorem states that changes in current taxes that leave the present value of taxes constant have no effect on consumption and the real interest rate3 Ricardian equivalence critically depends on the idea that the burden of the public debt is shared equally among the people alive at the time the debt is issued4 The burden of the debt is not shared equally whena There are current distributional effects of changes in taxes b There are intergenerational distribution effects c Taxes cause distortions d There are credit market imperfections NEW IN THE FOURTH EDITION1 Creditmarket imperfections have been moved to a separate chapterChapter 92 New Macroeconomics in Action Are Government Budget Deficits Sustainable3 All charts and tables have been updated to reflect new data4 Endofchapter problems have been added TEACHING GOALSThis chapter introduces the concept of intertemporal choice Intertemporal choice concerns the distribution of consumption and production of goods over more than one time period This chapter focuses on intertemporal consumption choice Without a credit Copyright2013 Pearson Canada Inc93Instructors Manual for Macroeconomics Fourth Canadian Editionmarket each individual must consume exactly his or her current disposable income in each and every period of time However many consumers would prefer to consume more or less than their current disposable income in each period Credit markets allow some consumers to be better off by redistributing consumption over time Each consumer may also choose not to participate in the credit market and these consumers can be no worse off for the existence of a credit market The existence of credit markets must therefore allow a Pareto improvementAn important first step for students is that they fully understand the meaning of the intertemporal budget constraint The first key point is that for given amounts of income consumption in the present can only be changed if there is a corresponding change in future consumption At an intuitive level this point is well understood by students taking out loans for college expenses However students are naturally focused on making decisions about current consumption and often lose sight of the fact that current choices effectively preclude alternative future choices One natural example of choice over time is consumers responses to lottery winnings Does the choice of a lumpsum payoff as opposed to a series of annual payments affect current consumption Does it affect current savings How would students respond to improved prospects for future employment incomeStudents should also understand that there is more to a change in the interest rate than an incentive substitution effect acting on the returns to saving Students should ponder the question of who wins and who loses from changes in interest rates Can everyone win Can everyone loseThe final and often most challenging issue is Ricardian equivalence Students often find it difficult to conceive of tax changes that do not at least implicitly involve changes in current or future government spending Discussions in the popular press often link tax increases to future increases in the size of government and tax cuts as promoting future spending discipline While these are valid political possibilities to ponder they are not the kinds of experiments that cast any light on the validity and relevance of Ricardian equivalence Possibly the best intuitive case for Ricardian equivalence is the example of a change in the tax withholding tables with no change in the tax tables The case of the withholding adjustment in 1992 which is discussed in the text is an excellent introduction to this topic CLASSROOM DISCUSSION TOPICSOne good way to get the ball rolling is to list some macroeconomic concerns students may have Ask students what they think about cultural and religious admonitions against borrowing Should everyone respect the principle Neither a borrower nor a lender be What about usury prohibitions on charging any interest to borrowers There are often tales of woe in the popular press about taking on too much consumer debt In the modern economy no one is forced to borrow or lend Ask students if they believe that there would be any benefit to outlawing credit Ask them if they benefit personally from credit markets Try to get them to separate the moral arguments and the economic argumentsCopyright2013 Pearson Canada Inc94
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