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?
[5 marks]
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. [5 marks]
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