Question from Past Macroeconomics Qualifying Exam[]

Fall, 2002 - Question four - at George Mason University
How would a temporary decrease in taxes affect aggregate consumption according to the following models:

  1. The standard Keynesian model?
  2. The life-cycle model?
  3. The Permanent Income Hypothesis?
  4. The neoclassical model with rational expectations?

How would the predictions of each of these models change in the presence of liquidity constraints? Explain.


  1. Keynes:In the standard Keynesian model a temporary decrease in taxes would lead to a temporary increase in income and due to the marginal propensity to consume ( ) to a proportionate temporary increase in consumption. ... The total effect will be c*B where B is the bonus forgone tax.
  2. The life-cycle model: With this model there is some short-term bias, since an agent has to interpret changes in transitory and permenant income. Depending on the specific assumptions that are made these could be negligable or signifigant effects.
  3. Permanent Income Hypothesis:A temporary decrease in taxes would have a negligible effect on aggregate consumption in the model of the permanent income hypothesis. Because a temporary decrease in taxes represents a change in transitory income, it would not affect permanent income significantly and consumption would therefore not change. The new wealth will be B/T where B is the bonus forgone tax and T is the number of periods that the agent will live.
  4. The neoclassical model with rational expectations: This view is that markets quickly adjust back to the new equilibrium. The aggregate demand will be stimulated and supply will adjust at a higher price level. No additional consumption will be maintained in the long-run.

What the presence of liquidity constraints mean is that individuals may not be able to borrow or borrow at higher interest rate than the return on their saving. Thus, this makes consumers to consume less than otherwise would, and save more as insurance against the effects of future falls in income. If such constraints are presence, then consumers even with current higher income from temporary lower tax would even consume less than predicted. This comes about since consumers now rather save more (instead of consuming) for the chance of unable to borrow in the future through liquidity constraints. The effect of tax decrease becomes smaller in every model with the presence of liquidity constraints.

Other Questions[]

This macro-stub needs improving.