lecture20 - Lecture 20 Economics W3213 Intermediate...

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Lecture 20 Economics W3213 Intermediate Macroeconomics Instructor: Mart´ ın Uribe Columbia University Spring 2016
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Announcements: This week in recitation: solution to midterm 2. Homework 8 will be posted later today, due next Wednesday.
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Lecture 20 Fiscal Policy and Ricardian Equivalence (3/4) 1
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Our goal continues to be to build a model of the equilibrium determination of consumption, investment, and the real interest rate to evaluate views I and II about the consequences of debt- financed tax cuts: View I: Tax cuts are expansionary. By increasing households’ disposable income, they stimulate consumption spending. But tax-cuts generate fiscal deficits and drive up interest rates, which may crowd out private investment. In summary, r , C , I , fiscal deficit . View II: Because tax cuts lead to higher public debt, sooner or later, the government must increase taxes to repay that debt (including interest). Hence tax cuts today lead to tax increases in the future. Households will not spend the tax cut on con- sumption goods. Instead, they will save the tax cut in the bank to be able to pay for the future expected increases in taxes. So current spending does not increase, the interest rate does not increase, and investment does not fall: Δ r = Δ C = Δ I = 0. This result is known as Ricardian Equivalence. 2
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A Two-Period Model of Consumption, Investment, Savings and the Interest Rate Basic Units of the Model: 1. The Government (previous lec- ture); 2. Firms (previous lecture);3. Households (previous lec- ture) Today: National Savings. The Equilibrium Interest Rate. Con- sequence of a debt-financed tax cut. The formal statement of the Ricardian Equivalence result. 3
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Results Thus Far. We have obtained the following relation- ships pertaining to the government, the firm, and households: T 1 + T 2 1 + r = G 1 + G 2 1 + r (1) S g 1 = T 1 - G 1 (2) I 1 = I ( r - ) (3) Profit = Π( r - ) (4) C 1 = 1 2 bracketleftbigg Y 1 - T 1 + Y 2 - T 2 1 + r bracketrightbigg (5) where S g 1 is government savings, T 1 lump-sum taxes, G 1 gov- ernment spending, I 1 investment, Π( r ) profits, C 1 consumption.
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