3. Budget Deficits & Fiscal Policy: Ricardian Equivalence

Question 1

What does Ricardian equivalence say about issuance of new government bonds?

Answer 1

If the government issues new bonds then it is effectively promising that taxes will be increased in the future

Question 2

What is the assumed BC for the single representative agent in the economy?

What is assumed to be the only saving instrument in this model?

Answer 2

Ct + qtBt+1 = Wt + Bt - Tt

where W=labour income, T=lump sum taxes

Government bonds: Agents buys them in this period to save for the next and receives the repayments from the ones that they bought last period (assumed due to law of no arbitrage)

Question 3

In the single representative agents BC, what happens if they buy more bonds (i.e. Bt increases)?

Answer 3

Taxes Tt must also increase in order to compensate for the extra saving

Question 4

How is the individuals intertemporal budget constraint obtained?

Answer 4

Obtained by imposing a no-Ponzi condition (lim(t→∞)⁡q_(0,t) B_(t+1) ≥0), and then iterating it forward

Question 5

Explain the meaning of the no-Ponzi condition for the individuals’ budget constraint

Answer 5

The agent will not save more than they need to in terms of bonds

Question 6

What is the formula for the individuals intertemporal budget constraint?

Answer 6

∑(t=0)^∞ q(0,t) c_t =B_0+ ∑(t=0)^∞ q(0,t) W_(t ) - ∑(t=0)^∞ q(0,t) T_t

Question 7

Explain the individuals’ intertemporal BC

Answer 7

PV of consumption = the initial value of held bonds + PV of income - PV of taxes that the agent must pay

Question 8

What assumptions are made for the individuals intertemporal BC?

Answer 8

• The agent lives forever
• No Ponzi
• The only saving instrument is bonds

Question 9

What does it mean if initial debt in the individuals BC is very high?

Answer 9

It means that the government owes a lot of money and will therefore have to increase taxes in future to repay its debt

Question 10

How do you obtain the Ricardian Equivalence result?

Explain

(3 points)

Answer 10

Sub the government BC into the individuals BC

In doing this, initial bonds B0 disappears

Hence the amount of bonds held by an agent is irrelevant for consumption

Question 11

What happens to any interest gained on bonds that individuals buy from the government?

Answer 11

They are later used to fund higher taxes that the government imposes in order to repay its debt

Question 12

What is the Ricardian equivalence result?

3 large points, Romer 2012

Answer 12

That the present value of the bonds that the household acquires in a period = the present value of the future tax obligation that will occur because the government must finance its debt in some way

Hence the bond does not affect the households consumption behaviour

The household saves the bond with interest until the proceeds are needed to pay the inevitably increased taxes at a later date

Question 13

Name a few limitations of the Ricardian Equivalence concept?

3 points

Answer 13

• Population turnover: Agents don’t actually live forever (as is assumed in the model), so some of the tax burden is actually borne by future agents (although there are problems with this argument)
• Agents don’t actually choose their consumption optimally (liquidity constraints and different interest rates)
• The path of government expenditures Gt, taxes Tt and debt qt is uncertain

Question 14

What are the two issues concerning the “finite life” argument against Ricardian equivalence?

Answer 14

• Care for the welfare of descendents can cause a series of individuals to act as one, with the same behaviour over time
• Lifetimes can be considered long enough to allow for Ricardian Equivalence to be a good estimate

Question 15

Outline the Permanent Income Hypothesis

Answer 15

Households behaviour is affected only by its lifetime BC.

The path of after-tax income doesn’t matter

Question 16

What are the two important failures of the Permanent Income Hypothesis?

Answer 16

• Most households have little wealth

- Predictable changes in after-tax income lead to predicable changes in consumption

Question 17

How is a failure in the PIH linked to a failure of Ricardian Equivalence?

Answer 17

If current disposable (after-tax) income has a significant impact on consumption for a given LBC then a tax cut offset by a future tax increase is likely to have a significant impact on consumption

Question 18

How can you test for Ricardian Equivalence?

3 points

Answer 18

Under RE…

• If the government looks to save more (spends less), national savings should not change
• If taxes or debt is changes, consumption behaviour should not change
• If the government increases spending or debt then there should be no effect of growth

Question 19

What is “altruism”?

Answer 19

The treatment of another’s utility as an extension of one’s own

Question 20

How many saving instruments are there in the Ramsey problem? Explain.

Answer 20

Two - Individual can either

Put the money in the bank (gains interest)

Buy government bonds (receive interest payments)

Question 21

Give the formula for the Ricardian equivalence result

Answer 21

∑(𝒕=𝟎)^∞𝒒(𝟎,𝒕) 𝑪𝒕 = ∑(𝒕=𝟎)^∞ 𝒒(𝟎,𝒕) 𝑾𝒕 −∑(𝒕=𝟎)^∞𝒒(𝟎,𝒕) 𝑮𝒕

Question 22

Give a statement that sums up the idea of Ricardian equivalence

Answer 22

Ricardian equivalence states that, given a path of government expenditures Gt, changes in the timing of taxes and corresponding debt levels will have no effect on consumption and output in the economy.