lecture21 - Lecture 21 Economics W3213 Intermediate...

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Lecture 21 Economics W3213 Intermediate Macroeconomics Instructor: Mart´ ın Uribe Columbia University Spring 2016
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Announcements: Homework 9 posted today, due Wednesday.
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Lecture 21 Fiscal Policy and Ricardian Equivalence concluded (4/4) April 6, 2016 1
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Some Unrealistic Assumptions Underlying the Ri- cardian Equivalence Result We will consider 3 unrealistic assumptions of the model which, if relaxed, lead to the breakdown of Ricardian Equivalence: Absence of borrowing constraints. All consumers receiving the tax cut are still around when taxes are raised in the future (no one dies in the interim). Lump-sum taxes. 2
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I. Borrowing Constraints Our model unrealistically assumes that everybody can borrow or lend as much as he/she wants, subject only to not playing Ponzi schemes (i.e., satisfying the intertemporal budget constraint). In reality, however, some people do not have access to credit. This is particularly true for young people (who have difficulty demon- strating that their future income is going to be higher than their current one) and for poor people (who often lack the collateral to back their debts). Empirical studies place the fraction of con- sumers subject to some form of borrowing constraint over 25 percent. 3
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Consider the problem of a consumer that is borrowing con- strained. How can we model this. Recall that the budget con- straints of the household period 1 C 1 + S p 1 = Y 1 - T 1 ; period 2 C 2 = Y 2 - T 2 + (1 + r ) S p 1 Thus far the only restriction we have put on borrowing ( S p 1 ) is that the household cannot borrow more than it can repay in period 2. Formally, the absence of borrowing constraints allowed us to combine the period-1 and period-2 budget constraints into a single present value budget constraint C 1 + C 2 1 + r = Y 1 - T 1 + Y 2 - T 2 1 + r with the restriction that C 1 0 and C 2 0. Graphically we can represent the budget set of the household (in the absence of borrowing constraints) as a line in the space ( C 1 , C 2 ) [insert graph with C1 on horizontal axis, C2 on vertical axis, and the intertemporal budget constraint with the endowment point labeled A] 4
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Suppose the optimal level of consumption (in the absence of borrowing constraints) is at point B. [insert graph with points A and B indicated. ] Now consider an economy in which households are borrowing constrained. To make things simple, assume that the borrowing constraint is such that households cannot borrow any funds at all. That is, the borrowing constraint takes the form S p 1 0 In the graph we can indicate the budget set under the borrowing constraint. All the points on the budget set but to the left of point A are no longer feasible because those points require the household to borrow in period 1.
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[insert graph with the new budget set] What will the household choose in these new circumstances? It would like to consume beyond his current disposable income, but is not allowed to. In this case, we have that current consumption is given by C 1 = Y 1 - T 1 that is point A , the endowment point. At point A the household is consuming simply its disposable income. Utility is lower than
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