Suppose that the lump-sum taxes in the current period decreases from 20 to 0 while the lump-
sum taxes in the future period and the real interest rate are assumed to remain unchanged.
(e) Derive the consumer's new lifetime budget constraint. What is the value of the
consumer's lifetime wealth?
(f) Draw a new graph that displays both the original and the new budget lin s. Include the
values of all the intercepts and the endowment points before and after tl e tax cut.
(g) Find the consumer's optimal choice of ($C_1$, $C_2$, $S$). Is the consumer a le ider or a borrower?
(h) What happen to current consumption, future consumption, and savings ($C_1$, $C_2$, $S$) in
response to a tax cut in the current period? Briefly explain the efiects of a tax cut in terms
of the substitution effect and the income effect.
Suppose that the consumer has recently taken the Intermediate Macroeconomic Theory and
Policy course and learned about the Ricardian Equivalence Theorem. In particular, the consumer
has learned that the tax cut of 20 in the current period must be financed through the issue of
government bonds by the amount of 20, and that the government must pay the principal and
interest of the bonds by imposing taxes in the future period (before the consumer dies).
(i) Given the real interest rate of 10%, what is the amount of extra taxes the consumer
expects to pay in the future period as a result of the current-period tax cut?
(j) Considering the future tax increase, what is the correct consumer's lifetime wealth after
the current-period tax cut? Find the consumer's optimal choice of ($C_1$, $C_2$, $s$) and explain
the result.
