Business Administration 4440Q/R/S/T Lecture Notes - Lecture 4: Risk Premium, Ricardian Equivalence, Budget Constraint
11 Mar 2015
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Recall the consumer"s budget constraint: c + c /(1+r) = y + y /(1+r) [ t + t /(1+r)] Recall further, that if ricardian equivalence holds, then the timing of taxes will not matter for present consumption. That is, the consumer cannot for some reason (perhaps he has a bad credit rating), borrow in the present period. However, he would borrow if he was not credit constrained. We want to show what may happen if taxes were lowered in the present period in this situation. To set this up, we start by considering two interest rates one for saving (lending), r1, and another for borrowing r2. This is, of course, what happens in financial markets since banks and other lenders make their profit by making loans at a higher rate than they pay savers. The diagram that illustrates this is reproduced below. The endowment point, e, is where we start.
