|Question||Consider the effect of rational expectations on consumption behavior.
a. Say that the government proposes a temporary tax cut of $20 billion, lasting for a year. Consumers witl1 adaptive expectations consequently assume that their disposable incomes would be $20 billion higher every year. What would be the resulting impact on consumption spending and GDP in the simple multiplier model of Chapter 22?
b. Next suppose that consumers have rational expectations. They rationally forecast that the tax cut is only for 1 year. Being “life-cycle” consumers, they recognize that their average lifetime incomes will increase by only $2 billion per year, not by $20 billion per year. What would be the reaction of such consumers? Analyze, then, the impact of rational expectations on the effectiveness of temporary tax cuts.
c. Finally, assume that consumers behave according to the Ricardian view. What would be the impact of the tax cut on saving and consumption? Explain the differences between the models discussed in a, b, and c.