Suppose a Caribbean government facing budget deficits asked their economic advisers to solve the following problem: they would like to reassure the credit rating agencies S&P and Moody's that they are serious about proposing a long-run plan that will eventually reduce the budget deficit further, but are also concerned that any contractionary fiscal policy might push the economy into a recession. One adviser suggests that the government pass legislation now that will raise taxes, starting two years from now. Assume throughout this problem that everyone believes that taxes will indeed rise two years from now.
i. Why would the simple Keynesian consumption function predict that this strategy would work?
ii. Many of the government's economists argue that the legislation will affect the economy now even if taxes do not increase for another four years. Explain their reasoning and the theory (or theories) they use.
iii. A small group of economists argues that the tax increase will have no effect on real GDP, regardless of when it takes effect. Explain their reasoning.
iv. Even if the theory cited by the economists in part III is correct, other economists argue that the tax increase will still affect consumption when it takes effect if people have liquidity or borrowing constraints. Explain their reasoning.