ECON5102 Assignment 3:
Consumption, Fiscal Policy and International Trade
Term 1 - 2023
• Due date 17th of April at 0900. Electronic submission through Moodle.
• Please include a complete and signed cover sheet (available on Moodle).
• Not all the questions in this Assignment will be marked (please see details in the
Course Outline)
• We will mark Part A, section a) and Part B, section a).
• You are free to type or handwrite your solutions. If you prefer to type them, make
sure to use Microsoft Word equations (or equivalent) to write down your
equations properly, otherwise reserve a space to handwrite them. If you prefer to
handwrite the whole assignment or parts of it, make sure the handwriting is clear,
well-organised and legible.
• Please read the questions carefully and go straight to the point.
• Please submit a single pdf file (including the cover sheet).
Part A: Consumption
Suppose that a household lives for two periods and has a utility function and intertemporal
budget constraint as follows:
(1, 2) =
(1
0.5 + 2
0.5)1−
1 −
ITBC: 1 +
2
1+
= 1 +
2
1+
a) Derive step by step the Euler equation faced by this consumer (define the Lagrangian and
then obtain first order conditions as we did it in the lecture). Explain the intuition of the Euler
equation.
b) Find a solution for optimal consumption in both period 1 and 2 as a function of the
parameter as well as the variables r, 1 and 2.
c) What is the ceteris paribus effect on consumption today (1) and tomorrow (2) of the
following shocks:
(i) An increase in .
(ii) A decrease in lifetime income.
(iii) An increase in .
d) Is there a condition where 1= 2? If so, what value must β assume?
Part B: Fiscal Policy
Consider an economy existing for four periods following the government budget constraint as
follows:
+1 = (1 + ) + −
a) Define each of the variables above and explain, in words, why the equality holds. Re-write
this budget constraint during each of the four periods that the economy exists.
b) The Australian government is trying to decrease the country’s stock of debt. Using the
equation above, discuss two possible ways this could be achieved using fiscal policy, only.
What challenges do you anticipate? (Hint: think of how tax collections change given changes
to government spending).
c) Using the elements in the equation above, discuss the likely effects on the future stock of
debt (+1) of an expansionary monetary policy. Explain.
d) What will the equation look like in the fourth period and what does this imply for the
economy as a whole?
e) Using backwards iteration from the fourth period, form and interpret (in at least two
sentences) the intertemporal government budget constraint for this economy.
Part C: International Trade
Solve exercise 4, chapter 19 (Jones 4th Ed, pp 544 - Jones 5th Ed, pp 556).