# ECO209Y5 Lecture Notes - Lecture 7: Ricardian Equivalence, Government Spending, Competitive Equilibrium

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17 Feb 2016
School
Department
Course
Natalie Ianniello
ECO209
Tewk
October 26, 2015
Lecture #7 – Consumption-Savings Decisions Part II
Government spending is exogenous
Period one constraint - G = T + B
- B = bonds (borrowing)
T = total taxes
T = Nt
- t = tax per individual
- N = number of consumers
Government can borrow in the two period model
They can borrow money and spend more than Nt in this model
Period two constraint – G1 + (1+r)B = T1
In period two it must repay what it borrowed
PLEASE NOTE THE DIFFERENT IN BIG T AND LITTLE t DURING THIS LECTURE
B = (T1-G1)/1+r
Competitive Equilibrium:
Consumer choices must be optimal
CE is set of:
- Endogenous consumption quantities (c, c1, s)
- Endogenous aggregate quantities (C, C1, T, T1)
- Equilibrium interest rate – r
Given:
- (t, T1, r) of each N consumers are optimal
- Credit market clears (aggregate private savings = government debt)
Ricardian Equivalence Theorem:
Theory – consider a given amount of government spending (G, G1). Suppose
government wishes to change current taxes T. Then as long as lifetime BC is
satised, there is no change in interest rate or consumption bundles
Consumers know tax cut today means higher taxes tomorrow
Fall in change in T, B will increase by the change in T
Next period, the government needs to repay an additional (1+r) change in T
Therefore, T1 will rise by (1+r) change in T to repay it
Dividing all of this by N will give you how much each consumer pays in taxes
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