Macroeconomic Theory and Analysis

Problem Set 6
Suggested Solutions

Problem 1: Ricardian Equivalence

1.1

Government Budget Constraint

The goverment budget constraints in the two periods are

g1 = b
g2 + (1 + r)b = sr2

(1)
(2)

Notice that government is forced to issue debt since there are no revenues
from taxation in the first period. The intertemporal budget constraint is:
g2
sr2
g1 +
=
(3)
1+r
1+r
Equation 3 tells us that the present value of government expenditure must
be equal to the present value of government revenues from taxation.

1.2

Households problem

The households problem is

max u(c1 , c2 ) = ln c1 + ln c2

(4)

c1 + s = y1

(5)

{c1 ,c2 ,s}

subject to:
c2 = (1 + (1 2 )r)s + y2

(6)

Combining equations 5 and 6 we get the intertemporal budget constraint:

c1 +

c2
(1 + (1 2 )r)

= y1 +

y2
(1 + (1 2 )r)

(7)

You can easily write down the lagrangean for this problem and get the
following Euler equation:
c2 = (1 + (1 2 )r)c1
The Euler equation depends on taxation.
1

(8)

1.3

Ricardian Equivalence

In this economy there is no room for fiscal policy in the sense that the
government cannot choose between debt and taxation to finance its expenditure. This is due to the fact that at time 1 the government can only use
debt. The Ricardian Equivalence does not hold in this economy since the
taxation is not lump-sum.

Problem 2: Ricardian Neutrality

2.1

Intertemporal budget constraints

The households intertemporal budget constraint is:

c1 +

c2
w2 (1 2 )(1 l2 )
= w1 (1 1 )(1 l1 ) +
1+r
1+r

(9)

The governments budget constraint is:

g1 +

w2 2 (1 l2 )
g2
= w1 1 (1 l1 ) +
1+r
1+r

(10)

We can combine the above equations to get:

c1 +

2.2

w2 (1 l2 )
w2 2 (1 l2 )
w1 1 (1 l1 )
1+r
1+r
w2 (1 l2 )
g2
= w1 (1 l1 ) +
g1
1+r
1+r

c2
1+r

= w1 (1 l1 ) +

Households problem

The households problem is:

max

u(c1 , c2 , l1 , l2) = ln c1 + ln(l1 ) + ln c2 + ln(l2 )

(11)

w2 (1 2 )(1 l2 )
c2
= w1 (1 1 )(1 l1 ) +
1+r
1+r

(12)

{c1 ,c2 ,l1 ,l2 }

subject to:

c1 +

The first order conditions are given by:

c1 : 1/c1 =

(13)

c2 : /c2 = /(1 + r)

(14)

l1 : /l1 = w1 (1 1 )

(15)

w2 (1 2 )
(16)
1+r
The Euler equation can be obtained by combining equations (13) and (14):
l2 : /l2 =

c2 = (1 + r)c1

(17)

So, the Euler equation does not depend on taxes.

The first order conditions for labor depend on taxes. Combining equations
(15) and (16) we get:
M RSl2 ,l1 =

l1
w2 (1 2 )
=
l2
w1 (1 1 )(1 + r)

(18)

Moreover, by combining equations (13) and (15) we get the following:

M RSl1 ,c1 = w1 (1 1 )

2.3

(19)

Competiteve Equilibrium

In order to define a CE we must first solve the problem of the firm. In

this economy, for each time t (t = 1, 2) the firm chooses ht to maximise
Aht wt ht . In a CE the firm earns zero profits and the condition A = wt
holds for each t = 1, 2.
A CE is an allocation {c1 , c2 , l1 , l2 , h1 , h2 , b, a}, a price system {w1 , w2 , r}
and a government policy {1 , 2 } such that, given the price system and the
government expenditures {g1 , g2 }:
households problem is solved
firms problem is solved
government budget constraint is balanced
bonds market clears a = b
labor market clears (1 lt ) = ht and wt = A for each t = 1, 2
consumption goods market clears yt = ct + gt for each t = 1, 2

2.4

Ricardian Equivalence

In this case Ricardian Equivalence does not hold since government is not
using lump sum taxation. The Euler equation does not depend on taxes,
but this is not sufficient for the Ricardian equivalence to hold. You can use
a more sophisticated argument to show that the equivalence does not hold
by playing with the intertemporal budget constraint.
From the households FOC we can recover that at the optimum:
l1 =
l2 =

c1
(1 1 )w1
c2
(1 2 )w2

The intertemporal budget constraint for the household becomes:

c2
c1 +
1+r


= w1 1

 w2 1 c2
c1
g2
(12 )w2
+
g1
(1 1 )w1
1+r
1+r

As we can see, the DPV of household resources is not independent from

the government fiscal policy. So even if a change in fiscal policy will not
affect the agent Euler equation it will affect the budget constraint.