Mary earns $50,000 in period 1 and in period 2. In period 1, the economy goes into a recession and the government decides to provide a fiscal stimulus with the goal of encouraging an increase in consumption spending. For this purpose, the government gives every citizen a tax rebate in the amount of $1,000 in period 1. However, the government decides to keep its spending at the same level as before. As a result, the government runs a budget deficit that it finances by issuing a government bond that it markets to citizens. The bond pays an interest of 2% in period 2 when it also matures.
a) Mary’s consumption in period 1 is $42,000. Now she receives the tax rebate check in the mail. What will she do? Will she go out and spend it on a new plasma TV that she always wanted to own? How will her current consumption in period 1 change? Explain carefully using the assumptions of the classical economic theory.
b) Imagine that Mary decides to use her $1,000 tax rebate to purchase the government bond. What will be the amount that she will earn from this investment in period 2?
c) The government decides to balance its budget through tax increases in period 2. What will be the total amount of the (lump-sum) tax the government will charge Mary in period 2 in its quest to close the budget gap?
d) Does the government succeed in its use of fiscal policy to stimulate Mary’s consumption in period 1? Explain.
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a) Classical economic theory assumes that prices and wages are highly flexible. Thus a tax rebate sent out to every citizen would increase the price of goods (including that plasma TV that Mary wanted to own) and likely not lead to an increase in her consumption. According to classical economic theory, government intervention will not lead to an increase in demand for goods - the classical economists believed that it was supply that generated demand rather than the other way around.
b) She will earn 2% of $1000 = $20
c) It will pay her the interest on the bond plus the tax rebate: $1000 + $20 = $1,020.
d) According to classical economic theory, no. Monetary policy can only affect prices, which means that the additional money that Mary would have received thanks to her bond interest and the tax rebate will only be used to pay higher prices for the goods she normally buys. Then, when she has to pay back the government in order to balance the budget, prices will fall. Her consumption will remain the same.
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