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Ricardian Equivalence And Credit Market Imperfection Notes

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Ricardian Equivalence and Credit Market Imperfection Topics

• Ricardian Equivalence

• Credit Market Imperfections - Asymmetric information and limited commitment

• Social Security Programs

Reading

Ricardian Equivalence

• The Ricardian Equivalence theorem states that a change in the timing of taxes by the government has no effect on consumption

• A tax cut is not a free lunch!
The government present-value budget constraint

• Introduce government to the two-period model
○ Government's current-period budget constraint:
○ Government's future-period budget constraint:
○ So government's present-value budget constraint:

• Total private saving is equal to the quantity of government bonds issued in the current period:

• Credit market equilibrium implies that the income-expenditure identity holds:

Key Points

• Ricardian equivalence

• Government PV budget constraint

• Consumer's wealth

• When might Ricardian equivalence not hold?

• Credit market imperfections

• Asymmetric information

• Limited commitment and collateral

• The financial crisis

• Effect on consumption of tax cut with credit imperfections

Definitions

• Asymmetric information = Would-be borrowers know more about their characteristics than lenders

• Limited commitment = Borrowers may choose to default. Lenders can overcome limited commitment with collateral

• The Ricardian Equivalence theorem states that a change in the timing of taxes by the government has no effect on consumption

Deriving consumer's wealth
○ There are N consumers
○ ∴ T = Nt
○ Government's budget constraint implies:

Formulae

○ ∴ consumer's wealth:

Ricardian equivalence in graphs Consumer's wealth remains the same so the consumption choice remains the same

• ∴ consumer's wealth:

• →

• Collateral constraint:

• Government's budget constraint implies:

• Government's current-period budget constraint:

• Government's future-period budget constraint:

• Lifetime budget constraint for a borrower:

• A tax cut financed by an increase in government bond is met by an increase in private saving

• The market real interest rate remains the same

• Lifetime budget constraint for a lender:

• Lifetime budget constraint:

• So government's present-value budget constraint:

• When might the Ricardian Equivalence theorem not hold?

• If the tax burden is not shared equally among consumers then the government can redistribute wealth through tax

• If taxes are distortionary

• i.e. labour income tax reduces incentives to work (recall the simple income tax model)

• If there are credit market imperfections

• If consumers have a different life-span than the government then there can be intergenerational redistribution

• i.e. social security programs Credit Market Imperfections - Asymmetric information and limited commitment

• Credit Market Imperfections and Consumption

• Assume that lenders face a lower interest rate than borrowers

• Government borrows and lends at the interest rate lenders face

• ∴ Ricardian equivalence does not hold, in general

Course Notes Page 30

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