Ricardian Equivalence And Credit Market Imperfection Notes

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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