Ricardian Equivalence and Keynesian Macroeconomics Essay

Explain what is meant by the term Ricardian Equivalence. Does it mean that public debt does not matter? Discuss This work outlines the meaning of Ricardian Equivalence and how it suggests that public debt does not matter to either the government or the society that government is representing. A discussion follows stating this may not be the case and why these two parties may have reason to care about public debt.

The work then goes onto conclude that there is obvious concern regarding public debt because of the current regime’s primary objective to reduce public sector debt, which alongside criticisms of the Ricardian Equivalence’s assumptions suggest it does not hold in the real world, and that public sector debt matters.

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Ricardian Equivalence describes David Ricardo’s basic idea that bonds and taxation are an equivalent form of finance for a government’s budget deficit (Hoover, 1988).

This theory implies that a bonds-for-tax swap does not lead to the consumer experiencing a wealth effect as they recognise a fall in taxation in the current time-period will lead to an increase in taxation in the future time-period.

This prediction causes the individual to increase current saving in order to finance the future taxation liability, and therefore has no overall effect on his/her overall wealth. The idea was resurrected and theorised by Robert Barro in 1974.

His model attempted to rectify some of the problems identified by Ricardo himself (see appendix 1) by assuming that individuals have infinitely long lives. This ensured the same individuals who purchased bonds in T1 would be taxed in period T21. A key assumption of the Barro model is that perpetual bond finance is not an option to the government suggesting that it must be paid off at some point in order to make the model plausible. The model’s conclusion is similar to Ricardo’s which is explained in appendix 2.

A problem with Barro’s assumption that agents live infinitely is that this in practice is not the case. An agent could avoid the tax payment in T1; die in the interim period between T1 and T2 thus avoiding the tax increase in T2. To address this problem, Barro formulated the ‘Over-Lapping Generations’ model described in Appendix 3. Therefore, having explained and understood what the Ricardian Equivalence is, it assumes that public debt does not matter to the government or society as taxation can always be increased in the future to finance such debt.

There are however a number of reasons which suggest this is not true and that both parties are concerned about public debt which shall be discussed in the next part of the work. 1 This theory of Ricardian Equivalence is regarded as the logical completion of the permanent income/life cycle hypothesis which assumes how consumption is determined by long-term average incomes (Seater, 1993) known as their level of ‘Permanent Income’ and not short-term alternations from variables such as taxation changes.

The current austerity measures in the UK are attempting to create revenue that can be used to reduce the levels of public debt. The concern is that if this does not happen, public debt could become explosive as bond interest rates continue to increase meaning credibility may be lost in the government’s solvency preventing new bond issues being purchased on the open market (see Appendix 4). The concern of the current administration in the UK is that government debt therefore does matter as it has the potential to catalyse a series of detrimental consequences.

Krugman (2012) criticises this approach suggesting that high amounts of debt relative to GDP do not increase the implied interest-rates on government bonds. This is evident in the UK, as government net debt has increased from 45% to 83% as a percentage of GDP (IMF, 2013) between 2008 and 2012 shown by Figure 3. UK 10 Year Government Bond Yields on the other hand for the same period have decreased from 4. 6% in 2008 to1. 9% in 2012 (Bank of England, 2013), shown in Figure 41. This shows the market’s confidence in government solvency questioning the conclusion drawn by the dynamics of debt and deficit analysis.

This is the current debate between the two political parties, with the Coalition siding with the opinion that public debt does matter and debt should be reduced. The timing of a debt-for-tax swap is very important regarding the effectiveness of fiscal consolidation and a reason government should care about public debt. Ricardian Equivalence firstly assumes the economy is functioning at full employment income, and therefore according to Keynesian theory has a relatively stable and low fiscal multiplier.

This is obviously not the case in practice as the economy can experience changes in multipliers due to the fluctuations of the business cycle, and therefore alters the effectiveness of fiscal consolidation on the level of national income. A second unrealistic assumption of Ricardian Equivalence is that 100% of the windfall agent’s gain from the debt-for-tax swap in T1 is saved. Agents may not recognise the consequence of this reduction in current taxation to be an increase in future taxation. Agents may therefore use this additional income to increase consumption in T1. This period also includes the UK’s downgrade of creditworthiness from AAA to AA1 by Moody’s credit agency. This move was unexpectedly followed by a fall in 10 Government bond yield rates from 2. 1% on the day of the downgrade to 1. 9% a week later , again highlighting the confidence in the government’s solvency (Bloomberg, 2013). Source: Bank of England If the second assumption of the previous paragraph is not assumed, the reduction in taxation in T1 of the Ricardian Equivalence is a decrease in withdrawals from the circular flow of income.

In other words, there has effectively been an increase in injections. This injection is assumed to have a fiscal multiplier effect and for illustrative purposes, we assume the multiplier to be 1. The time arrives where the government increases taxes to finance the repayment of bonds which according to Ricardian Equivalence; will be the same amount taxes were reduced in T1 plus the implied interest rate on bonds. The time between the issuance of the bonds in T1 and the period of T2 they are due to be redeemed, the economy has entered a downturn.

Assuming the Keynesian view that fiscal multipliers are higher in a period of low/negative growth than an expansionary period, the increase in taxes of the same amount they were reduced in T1 would lead to a proportionately larger reduction in income than the initial increase in income from the ‘injection’. If this debt-for-tax swap had not occurred and the increase in taxes had been implemented in T1, the severity of the fall in national income would not have been as large as the multiplier would have been lower.

The aim therefore to conduct a successful fiscal consolidation programme with the use of both debt and tax finance is to impose debt finance when fiscal multipliers are high (to derive the positive effects on national income) followed by an increase in taxation to repay the bond principal and servicing costs when fiscal multipliers are low (therefore having a lesser negative effect on national income). This issue of optimum timing of debt-for-tax swaps in order to impose fiscal consolidation is another reason to care about public debt.

A third issue which questions whether tax and bond financed deficits are equivalent forms of finance is the redistributing effects of seigniorage and the inflation tax. This describes where an increase in the money supply (inflationary finance) provides the government with revenue to acquire real resources without an apparent cost. This revenue is known as seigniorage. This relates to our discussion as a government could have reduced taxes by ? x in T1 and during the interim period between the increase in taxes in T2 may undertake inflationary finance (Burda and Wyplosz, 2005).

Due to the positive effects of seigniorage on government finances, the corresponding increase in taxes in T2 may not have to be as large as the reduction in T1 therefore making tax and debt finance not equivalent and public debt something to be concerned about. The second by-product of an increase in the money supply is an unanticipated increase in the rate of inflation. This can also help improve a government’s finances through a concept known as the inflation tax, which refers to inflation eroding the real value of the government’s debt liabilities.

This mechanism refers to how an increase in the money supply devalues a currency’s real value while leaving the nominal value unchanged. This reduces the real value of the government’s debt and bond holders experience a capital loss. This net gain for the government implies that future taxes do not have to rise by as much as the initial reductions in T1 meaning that tax and bond finance are not equivalent. The effect of the inflation tax therefore means that debt does matter as the debt’s real value can be reduced by inflationary finance, and therefore a concern for both the government and the bond holders.

The final issue examining why public does matter refers to how the type of government purchase effects future taxation. If a government were to spend funds on a current-consumption project such as building a park, there would be no increase in T2’s income and therefore taxes would have to rise. If the funds were spent on an investment project such as a new University, it would provide a rate of return high enough to compensate not raising taxes in the future by the same amount they were reduced in T1.

In this case, bond and tax finance are not equivalent and a reason why agents and the government care about public debt as it has directly generated income without a corresponding increase in taxation. This essay has explained Ricardian Equivalence and evaluated one of its key conclusions which states that the amount of public debt does not matter. The series of points above suggests that debt does matter which have theoretical and practical support.

The alternative view, which is associated with Ricardian Equivalence, suggests that debt does not matter but this view has many simplifying assumptions meaning practical application is improbable. Appendices Appendix 1| Ricardo’s Critical Assessment of Ricardian Equivalence| Ricardo criticised his own theory suggesting that the economic agents may not recognise that the temporary reduction in taxation will be reversed by an increase in the future meaning agents may not save 100% of the windfall.

An effect of this is that consumption must increase as it is the second and only remaining component of the right-hand side of the disposable income identity (Disposable Income = Consumption + Savings identity) therefore deteriorating the savings available to pay for the increases in taxes in the future. His second criticism suggested that a tax-for-bond swap would be advantageous to the owner of bonds if they were to die or emigrate before the tax in T2 was implemented. | Appendix 2| Barro’s Infinite Lives Model| Barro used the intertemporal choice model to show two time periods of how an infinite life is split.

The first period, T1, indicates when debt is issued in-place of taxation and the second period, T2, is when taxes rise to finance the implied interest-rate of that same debt plus the par value at maturity. This is shown in Figure 1. The x-axis and y-axis respectively represent consumption in T1 (current time-period) and T2 (future time-period) with the budget constraint joining the two points of maximum income conceivable in T1 and T2 given the agent’s level of income and the interest rate shown by the slope of the budget constraint (1+r).

The position of the indifference curve is determined by the economic agents’ preferences for consumption and saving in the two time periods for a given amount of income, Y1 – T1. In this example, the agent’s preferences for current and future consumption are represented by point b, showing a lower proportion of income consumed in T1 relative to income consumed in T2 and therefore by – definition, higher saving in T1 relative to T2. Suppose a government decides to implement a bonds-for-tax swap as a means of financing government budget deficit. This implies an increase in the agent’s current level of disposable income from Y1 – T1 to Y1 – T1‘ (Y1 – T1’+D, with D representing the lump sum from the tax reduction) shown by the move from a to c. If this scenario was left unchanged, the amount of disposable income in T2 would be reduced because of the expected increase in taxation to finance the bond redemption and implied interest rate costs, shown by the y-axis intercept of point c (Y2 – T2 – (1+r)D).

As this agent foresees this increase in future taxation, the agent increases his/her level of saving in T1 to finance future tax increases of the amount equal to the debt redemption and debt servicing costs incurred over time-period one. The agent therefore moves back to his/her original position b to finance this signifying that tax and bond finance are equivalent according to this agent’s consumption decisions (Hoover, 1988). If the agent did not anticipate the future increase in taxes, the budget line would shift to B2 allowing the agent to increase consumption in T1 to C1’ while leaving consumption in T2 unchanged.

The agent’s in this scenario increases his/her utility through the move from U1 to U2. Ricardian Equivalence assumes 100% in anticipated and alters their marginal propensity to save accordingly. | Appendix 3| Over-Lapping Generations Model| The ‘over-lapping generations’ model assumes that agents live for one period only dying just after the next generation is born. This model interprets a debt-for-tax swap to mean a reduction in taxation in period 1 to be imposed on the parents (generation 1) followed by an increase in taxation in period 2 imposed on their children (generation 2).

Bearing this in mind, a second major difference from the ‘Infinite Lives Model’ is that the parents’ utility is made up of their own plus the utility of their children , which can be seen by Equation 2: U = U(C1, U*) | (Equation 2)| where C1 = own consumption U* = level of children’s utility | | This can be shown in Figure 3 as the intertemporal budget model now represents the parents’ income and consumption on the x-axis and the children’s income and consumption on the y-axis.

As the children’s utility is a function of the parent’s utility, it is beneficial for the parents to leave bequests to their children in period 2 in order to increase their level of consumption. This is done at a cost of lowering the parent’s consumption level which can be shown in Figure 3. The initial level of income and consumption for parents is Y1-T1 and C1 respectively. This shows parents are saving BQ which will be paid as a bequest to their children to facilitate consumption at C2. A substitution of debt-for-tax increases the after-tax income of the parents to Y-T+D.

The parents however foresee that the initial reduction in taxes plus the debt servicing costs will have to be repaid by their children in T2 and therefore increase the bequest to BQ’. This offsets the increase in taxes felt by their children leaving consumption unchanged at C2 for the children and C1 for their parents. This mechanism therefore means that debt repayment is undertaken by the same agents who initially benefitted from the tax windfall in T1. The conclusion of this is that tax and debt finance are the same, and the Ricardian Equivalence holds (Hoover, 1988). Appendix 4| Dynamics of Debt and Deficits: Equilibrium Point Derivation| This issue can be examined by referring to the debt-to-GDP ratio, which is known as an indicator of the government’s ability to pay its debt. This is the ‘Dynamics of Debt and Deficits’ theory which is shown in Figure 2 on page 7? DbDb E Rate of growth of debt . Point E represents an equilibrium debt-to-GDP ratio where the rate of growth of government debt is equal to the rate of growth of income, and this stable point is shown by equation 1.

DbY= cg-(r-p)| (Equation 1)| Equation 1 Derivation:1) ? Db=cY+r-pDb(Change-in Debt = constant of Y which is the primary deficit + outstanding amount of debt multiplied by the real interest rate)2) This is divided by Db to give the growth of debt:? DbDb=cY+r-pDbDb? DbDb=cYDb+ (r-p)3) This corresponds to the rate of growth of income, g:g=cYDb+ (r-p)? ?DbDb=g 4) If the two are combined, the debt-to-GDP ratio is represented as shown below:DbY=cg-(r-p)The rate of growth of debt, Db, equals the rate of growth of income, g.

Referring back to the equilibrium point E, it firstly assumes the real rate of growth, g, is more than the real interest rate and secondly; the primary deficit is a constant proportion of income. As the real rate of growth is assumed to be higher than the real interest rate (nominal interest rate minus the price level), the debt-to-GDP ratio is assumed to be stable as the growth of the economy is sufficient to reduce the impact of interest payments on the debt burden and therefore remains at equilibrium point E.

If the real interest rate goes above the real rate of growth plus a maintained primary deficit, debt can become explosive as interest payments on current debt would be rising faster than GDP and therefore servicing the debt interest is increasing the debt burden. The important observation is that the interest rate increases could be caused by further bond issuances due to the increased risk premium of holding the debt.? DbDb DbY Source: Triantafillou DbY Rate of growth of debt DbY g=? YY r- p | References Bloomberg. (2013) 10 Year Govt Bonds 10 Year Note Generic Bid Yield. Online][Accessed on 2ND March 2013] http://www. bloomberg. com/quote/GUKG10:IND/chart Burda M and Wyplosz, C (2005). Macroeconomics: a European text. 4th ed: Oxford University Press. Pages: 167-173. Carlin, W and Soskice, D. W (2006). Macroeconomics: imperfections, institutions, and policies: Oxford University Press. Pages: 176-181, 206-209, 220-223. Hoover, K. D. (1988). The Limits of Policy: Micromodels. In: The New Classical Macroeconomics: A Sceptical Theory: Oxford: Basil Blackwell. Pages: 139-163. International Monetary Fund. (2013) General Government Net Debt. Online][Accessed 2ND March 2012] http://www. imf. org/external/pubs/ft/weo/2012/02/weodata/weorept. aspx? pr. x=39&pr. y=12&sy=2005&ey=2013&scsm=1&ssd=1&sort=country&ds=. &br=1&c=112&s=GGXWDN_NGDP%2CGGXWDG_NGDP&grp=0&a= Krugman, P. (2012). Nobody Understands Debt. The New York Times. [Online][Accessed on 2ND March 2013] http://www. nytimes. com/2012/01/02/opinion/krugman-nobody-understands-debt. html? _r=0 Pentecost, E. J. (2000). Macroeconomics: an open economy approach. Basingstoke: Macmillan. Pages: 192 -208. Seater, J. J. (1993). Ricardian Equivalence’, Journal of Economic Literature. 31, Pages: 142-190. Triantafillou. P. (2013). The Dynamics of Debt and Deficits. Manchester Metropolitan University. 54-page handout, distributed 7TH January 2013 in Lecture 1 for module ‘Principles’. Bibliography Barro, R. J. (1974). Are government bonds net wealth? Journal of Political Economy. 82, Pages: 1095-1117. Chamberlin, G and Yueh, L. Y. (2006). Macroeconomics. London: Thomson Learning. Pages: 95-107 Stanley, T. D. (1998). ‘New Wine in Old Bottles: A Meta-Analysis of Ricardian Equivalence’, Southern Economic Journal. 64 (3), Pages: 713-727.

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