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B) Second hypothesis
3. The long term adjustment
5.6 The Ricardian Equivalence (RE)
The government expenditures are financed by raising tax revenues. An increase in government expenditures increases the consumption expenditures. This is
C Y
1∆
. The consumption expenditures may decline as taxes increase, which further reduces the disposable income of people.Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more
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Advanced Macroeconomics
166
Modern Macroeconomics
If the government expenditures are tax financed, then
1
1 1
( )
Y G C Y T G C Y C G
∆ = ∆ + ∆ −
= ∆ + ∆ − ∆
Or
1 1
(1 ) (1 )
Y C G C
∆ − = ∆ + −
Or
1
| |
tax 1 G bonds
Y G Y
C
∆ = ∆ < ∆ = ∆
− (5.22)
The IS curve shifts to the right when there is a large bond financing rather than tax financing. Bond financing does not reduce the disposable income. A tax reduces the disposable incomes of people and lowers the aggregate expenditures. The Ricardian equivalence is named after the classical economist David Ricardo (1772–1823). He argued that the impact on real income is the same whether government expenditures are tax financed or bond financed. Whichever financing a government uses to finance its expenditures, the IS curve shifts to the left. Due to the high expenditures, the government issues bonds, and pays interest on these bonds, in the future. Therefore, the government substitutes the current tax that it could have imposed today to finance its expenditures with future tax. Individuals are self-motivated and attempt to maximize their profits. They save more and try to minimize paying taxes. Their savings will be used up to pay the rise in taxes. Therefore, individuals will save money which is equivalent to the increase in future taxes.
The Ricardian Equivalence (RE) is based on two assumptions:
1. Individuals are forward looking and they have perfect foresight.
2. The government budget is intertemporally balanced.
When a government finances its expenditures by selling bonds, households recognize this as a balanced budget. There will be more taxes in the future, to allow the government to pay back the borrowing on the bonds sold today. Therefore, the present burden of taxes is current taxes plus the present value of taxes in the future. This is required to pay the interest on current bond sales.
The market price for bonds is
1 P
B= i
If ∆B is the number of bonds sold to finance the increased government expenditures then the nominal value of bonds is:
Value of bonds =
P B
BB i
∆ = ∆
(5.23)The annual interest payments on the bond sold will be
i ( B ) B i
= ∆ ∆
Advanced Macroeconomics
167
Modern Macroeconomics The government pays interest on bonds at certain periods. To be able to pay the interest, the government will have to raise taxes. Therefore,
Pv (future taxes) = PV (interest payment) (1 ) (1 )2
B B
i i
∆ ∆
= +
+ +
B i
= ∆
(5.24)The real present value of implied future taxes will then be =∆ipB. During the current period, the tax burden on individuals who have perfect foresight and realize the intertemporal nature of the budget, will require that the individual follow the Ricardian Equivalence proposition.
RE B
T T ip
= ∆ (5.25)
Current expenditures are financed by current taxes and the real value of debt issued to finance current expenditures is given by:
P BB B p ip
∆ =∆ (5.26)
The current period budget constraint of the government can then be written as:
G T B ip
= +∆ (5.27)
The right hand side is the current period tax burden experienced by people. It can be further stated as:
REd RE
Y = −Y T = −Y G (5.28)
The current burden of the government is the current taxes levied, T , which affects the amount of disposable income of individuals. In the Ricardian approach, the current burden of government by contrast is the goods and services it absorbs.
The goods market equilibrium is given as:
0 1 2
1 0 1 2
( ) ( ) ( )
(1 ) (1 ) (1 ) ( )
e e
e e
Y C I G
C C Y G C i a b i G
Y C C G C C a b i
= + +
= + − − − Π + − − Π +
− = + − − − Π + − − Π (5.29)
Advanced Macroeconomics
168
Modern Macroeconomics
This leads to two propositions:
1) Increases in expenditures are financed by the government through levying taxes or issuing bonds
Therefore,
1 1
1 1
1 C Y
G C
Y G
−
∆ = =
∆ −
∆ = ∆ (5.30)
The IS curve considering the RE effect will shift the same distance irrespective whether the government expenditures were financed with taxes or bonds. This is because bond sales impose the same burden on individuals as the taxes that would have been imposed in their place.
2) A tax cut financed by bonds sales has no effect on output.
The bond sales in the present have an effect on future taxes. Taxes will have to be levied to pay back the interest on the bonds. The present value of higher taxes is equal to the present tax cut.
The disposable income can again be defined as:
Yd Y T C S S Y C T
= − = +
= − −
(5.31)
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axa_ad_grad_prog_170x115.indd 1 19/12/13 16:36
Advanced Macroeconomics
169
Modern Macroeconomics
Considering RE, ( , )
( , )
e e
C C Y G i
S Y C Y G i T
= − − Π
= − − − Π − (5.32)
G is unchanged when current taxes are substituted by debt.
S T
∆ = −∆
The taxes have an equal and opposite effect on saving. Tax cuts increase the disposable income by the amount (Y− ∆T) and a fraction
C Y
1( − ∆ T )
of this is spent by the individual. The IS curve shifts upwards. The RE approach explains that when government dissaves, the private sector saves and the aggregate savings in an economy do not change much. People save to pay for the anticipated higher taxes in the future when the government dissaves.5.6.1 Criticisms
1. The Ricardian Equivalence (RE) gives people more freedom to look ahead in the future.
People are short sighted. There is no fixed time and future time is not yet given. Most households struggle to satisfy their minimum credit needs.
2. The Ricardian Equivalence is true to a certain extent. Consumers may make cuts on their high consumption. They reduce it with available credit.
3. In India, the financial system is underdeveloped. People do not know much about bond financing.
4. Though individuals may not have perfect insight, they are forward looking as any policymaker who is smart realizes. Individuals anticipate policies, figure out if they are credible and take offsetting action if necessary.