Suppose that the level of annual taxes in a country is $1000 and
the nominal interest rate is 10 percent. Assume that the government
cuts taxes to $900 in year 1, then raises them to $1110 in year 2, and
then restores them at $1000 in year 3, leaving them there indefinitely.
If consumption is three-quarters of permanent income, it will
1. remain unchanged.
2. increase permanently by $75 in year 1.
3. increase permanently by $7.50 in year 1.
4. increase by $7.50 in year 1 and decline by
$7.50 in year 2.
Choose the correct option.