If a nation experiences an output shock and wishes to borrow to smooth consumption, how much of consumer spending must it forgo each year to achieve consumption smoothing and maintain the long-run budget constraint? A) an amount equal to r^*/(1 + r^*) of the output shock B) an amount equal to 20% of its output shock C) 95% of the output shock D) an amount equal to r^* as a percent of the former level of GDP

Question

Quizplus · Accepted Answer

The amount that a nation must forgo each year to achieve consumption smoothing and maintain the long-run budget constraint is calculated using the permanent income hypothesis. According to the permanent income hypothesis, a nation can smooth its consumption by borrowing an amount equal to r^**S1P0/(1 + r^*), where r is the interest rate, ^{is the shock to output,} is the elasticity of output with respect to permanent income, and S1P0 is the initial level of permanent income. This formula calculates the amount that a nation can borrow in the first year. In subsequent years, the nation must repay the principal and pay interest. To determine the amount that the nation must forgo each year, the formula is simplified to r^**S1P0/(1 + r^*). Therefore, the answer is A.

If a Nation Experiences an Output Shock and Wishes to Borrow