Macroeconomics This question is related to A Two-period Model: The Consumption-S

Question

Macroeconomics

This question is related to A Two-period Model: The Consumption-Savings Decision and Credit Markets

Consider an economy in which consumers have identical preference and income.The income is determined randomly and exogenously in each period. Consumersprefer smooth consumption over time. Production does not involve capital so thatthere is no investment. The government balances its budget each period by collecting a lump-sum tax to nance an exogenous amount of government purchases.

Suppose this is a close economy. Will consumption be less volatile than income in the competitive equilibrium? Explain. (Suppose this is a small open economy facing exogenously given price and interest rate in the international market.) Willconsumption be less volatile than income in the competitive equilibrium? Explain.

Please anwer the question in comprehensive way or easy way to understand. Thank you.

Explanation / Answer

The consumption and savings in a two period model are a intertemporal choices based on interest rate and level of income.Given that consumers have identical preferences and income and production does not need capital investment with a balanced budget in place.

In such a case a closed economy will have less volatile consumption becasue the income in hand is stable and there is no effect of interest rates , whereas when the international market comes into picture the decision depend on volatile inteerest rates .When the interest rrates risse people decide to save more than spend on consumption to earn returns which makes consumption more volatile than in a closed economy.If we look at the closed economy government keeps economy under balanced bdget so people can continue to keep their preference same with given level of income which may not be the case in a open economy.

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