Twin Deficit

Question 1

What is the twin deficit hypothesis

Answer 1

if, then

If fiscal deficit, then there would also be a current account deficit

Question 2

What is the equation for the primary fiscal deficit?

Answer 2

Primary fiscal deficit =

Question 3

What is the equation for the secondary fiscal deficit?

Answer 3

Secondary fiscal deficit =

Question 4

Dervive the economy with a government sector budget constraint

Answer 4

Gov budget:

PDV of Gov. spending = PDV of tac revenue + initial Gov. assets

Period 1: Period 2:

Transversality condition:

Households budget:

Putting in Gov. budget constraint into household:

PDV of private + public consumption = PDV of endowments + initial foreign wealth

For ease

Optimal consumption in the economy with a government sector budget constraint:

Question 5

What does the obudget constraint for an economy with a Gov. sector ​ show?

Answer 5

Economy’s resource constraint depends only on G₁and G₂and is INDEPENDENT of T₁and T₂ timing of taxes is irrelevant for optimal allocation + tax cuts have NO effect on CA

Question 6

Prove that the timing of taxes is irrelevant for optimal allocation + tax cuts have NO effect on C, + therefore on CA

Answer 6

Gov. budget constraint:

Assume , and as gov. spending remains unchanged:

Tax cut in period 1 must leave PDV of taxes unchanged****a tax cut in period 1 leads to a tax increase in period 2

HH constraint:

From HH budget constraint in period 1 :

as-

If increase, households save the equivalent in amount to smooth consumption in p1.

Question 7

What does ricardian equivlance show?

Answer 7

a reduction of government savings via a tax cut in the current period, that leaves government spending unchanged, has no real effects as households increase their saving by an equivalent amount leaves consumption allocation unchanged àCA unchanged, twin deficit hypothesis fails

Question 8

How does CA change when T₁ or T₂ changes but G spending remains the same?

Answer 8

CA is unchanged due to richardian equivalence

Question 9

How does the CA change when G spending changes?

Answer 9

Consumption falls in response to a temporary increase in government spending, but by less than the increase in government spending (as household uses assets to smooth consumption by borrowing more)TB deteriorates, +CA deteriorates, but both by less than the increase in Gov. spending. Twin deficit hypothesis holds.

Mathematical Proof:

and

Question 10

Why may does the Ricardian equivalance fail?

Answer 10

Tax cuts must also cause CA to fall, due to:

1. Borrowing Constraints
2. Intergenerational effects
3. Distortionary Taxation

Question 11

Explain how borrowing constraint cause Ricardian Equivilence to fail

Answer 11

. P1 HH budget constraint: Borrowing constraint: .

Assume borrowing constraint is binding: consumption basket is not at optimum level

+ we observe twin deficit

In order for a tax cut to lead to a CA deterioration of the same magnitude, 100% of households benefiting from the tax cut must have borrowing constraints.

Question 12

Explain how intergenerations effects cause Ricardian Equivilence to fail

Answer 12

àGeneration that benefits from the tax cut are not the same as the one that pays for the future tax increase / agents are not forward looking.

Assume households are 1-peroid lived ( assume

Generation alive in P1 budget constraint:

Generation alive in P2 budget constraint:

Gov. budget constraint:

observe twin deficit

Question 13

Explain how distorionary taxes cause Ricardian Equivilence to fail

Answer 13

P1&2 HH budget constraint :

s.t. budget constraint: (wedge between MRS and 1+r)

Substitution effect:If, then household should increaseand decrease decrease inmost likely would lead to increase inandàRicardian equivalence fails

Checking income effect = 0

P1&2 Gov. BC: & -

Assume Gov. spending is exogenous, and taxes are so that the budget constraint is satisfied

Combing household and Gov. budget constraint: - no change economy wide resource constraint (no income effect)

increases and

Question 14

What are Ramsey Optimal Tax conditions?

Answer 14

1. Household maximises:
2. Household budget:
3. Gov. budget:
4. No arbitrage condition:

Question 15

Work the solution of Ramsey Optimal Tax policy

Answer 15

1. Combine HH and Gov. budget constraint à
2. Max utility subject to this aggregated constraint (less constrained) - set so that (1) holds
3. Pick so that (4) holds
4. Sub into household constraint + solve for - set so (2) holds
5. Combine the combined BC with the HH BC (2) to show (3) holds

Question 16

What does Ramsey Optimal Tax Policy show?

Answer 16

Shows that the Ramsey optimal allocation in an economy with distortionary taxes = optimal allocation economy with lumpsum non-distortionary taxes

Gov chooses taxes which don’t distort choices