Question

Suppose there is a credit market imperfection due to limited commitment. As in the setup with collateralizable wealth we examined in this chapter, each consumer has a component of wealth that has value pH in the future period, that cannot be sold in the current period, and that can be pledged as collateral against loans. Suppose also that the government requires each consumer to pay a lump-sum tax t in the current period, and a tax t′ in the future period. Also suppose that there is limited commitment with respect to taxation. That is, if a consumer refuses to pay his or her taxes, the government can seize the consumer’s collateralizable wealth but cannot confiscate income (the consumer’s endowment). Assume that, if a consumer fails to pay off their debts to private lenders and also fails to pay their taxes, the government has to be paid first from the consumer’s collateralizable wealth.

(a.)Show how the limited commitment problem puts a limit on how much the government can spend in the current and future periods.

(b.)Write down the consumer’s collateral constraint, taking into account the limited commitment problem with respect to taxes.

(c.)Now, suppose that the government reduces t and increases t′ so that the government budget constraint continues to hold. What will be the effects on an individual consumer’s consumption in the present and the future? Does Ricardian equivalence hold in this economy? Explain why or why not.

Answer 1