Notes 3/10/14 ECON 362Review of Permanent Income Hypothesis and Ricardian EquivalenceGovernment budget constraint: G1+G2/(1+r)+…=T1+T2/(1+r)+…1st situation: Holding govt expenditure constant, govt imposes temporary tax cut: T1 decreases, to satisfy budget constraint, taxes must increase in future: T2 increases.How does this effect consumer?Consumers budget constraint: C1+C2/(1+r)+…=a+(Y1-T1)+(Y2-T2)/(1+r)+…This tax cut will not stimulate the economy because people wont spend the money due to consumption smoothing. They will save the money to pay for the future tax increase.Now suppose government spending increases: G1 increases by ΔG, to satisfy the equality, ΔG1 must equal ΔT1How does this effect aggregate demand?Yd=C+I+GThe decrease in consumption is less than the increase in govt spending, causing aggregate demand to increase. This will cause a future decrease in aggregate demand. Temporary changes in G1 can be stimulatory, Permanent changes