1) Ricardian equivalence observes that a cut in current taxation financed by future tax increases has the same present value as tax cuts financed by government bonds. It argues this means tax cuts will not affect short-run or long-run consumption. 2) The document uses household savings functions to show that if a tax cut is financed by bonds, household savings will increase by the full amount of the new bonds, so consumption remains unchanged. 3) It discusses how liquidity constraints can impact household consumption decisions. A binding liquidity constraint means a household cannot borrow and must consume all current income, leaving them worse off than with no constraint.

1. Student number: 557699
Question A
Ricardian equivalence observes that, for a constant level of government expenditure, a cut in
current taxation followed by an increase in future taxes will have the same discounted present
value as the tax cut. Ricardo argued that both bond and tax financing of government
expenditure are equivalent; therefore a deficit financed cut in current taxes would have no
effect in either the short- or long-run. This means that governments shouldn’t worry about the
size of their deficit as it reflects the size of their spending. This arises because the present
value of taxes can only change if the government changes the present value of its spending,
which under Ricardian equivalence is assumed constant.
A fall in taxes which is financed by government bond issue will increase the current
disposable income for the population, however there is an increase in future tax liability to
cover both the interest payments on the new bonds and to pay the principal back from bonds
which have reached maturity. Because the discounted present value of the higher future tax is
equal to the tax cut, households are therefore no better or worse off by the reduction in
current taxation over the course of their life. This implication means that households will not
change their spending; however households will increase their saving by the full magnitude
of the reduction in taxes. Since the increase in household saving is exactly equal to the
increase in government bond issue (borrowing), the interest rate which clears the bond market
is unchanged as both the supply and demand for loanable funds schedules shift in equal and
opposite direction.
To illustrate that a bond financed tax reduction has no effect on private sector consumption
because private sector saving increases by the full extent of the bond issue; we can consider
households saving function which is given as
Where S1 is household saving, Y1 is household income for each period (given exogenously),
T1 is the initial level of taxation, and is household consumption. This is a standard savings
function which shows that households save what is left of their disposable income (
after consumption. Because the decrease in taxation is equal to the value of the bond issue
Where shows the post-cut tax level and B is bond issue. This gives the new savings
function post tax reduction, as
.
Using the previous formula to find the change to household saving then gives
.
This final equation shows that the value of the bond issue is equal to the increase in savings;
therefore household consumption, C1, does not change. This finding isn’t consistent with the
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Keynesian viewpoint which would expect consumption to rise.
In multi-generational models where households have the opportunity for capital accumulation
over the generations, the above situation continues. Ricardian equivalence assumes that each
generation’s utility also depends on the utility of the next generation. This means that given
reduction in current taxes for generation 1, generation 1 will save the full amount of the
reduction in taxes which will be passed on to the next generation as gross bequest, which is
assumed to not be negative. The higher level of gross bequest, because of the higher savings,
means that the next generation can continue to consume at the same level as before the tax
cut. Therefore, there is no capital accumulation as the savings from the previous periods are
used up in next period consumption.
Question B
A liquidity constraint restricts a household’s ability to borrow against their period two
income to increase their period one consumption. The liquidity constraint can either
bebinding (which means that the household would like to borrow in period one but is unable
to due to the constraint) or it can be non-binding(which means that the constraint does not
affect the household’s consumption in either period).
Ahousehold which is subject to a binding liquidity constraint in period one by the constraint
will choose to consume all their disposable income of in period one.
The household’s budget constraint is given by the equation
Considering the graph below; without a liquidity constraint the household would use their
endowment income, E, to consume at point B which is where their utility is maximised on
utility curve U’.The individual would choose to consume at point B because that is where
their indifference curve is tangential to the non-liquidity constrained budget line YEBX.
Therefore because point B is to the right of the initial endowment point, the household would
choose to borrow if there is no liquidity constraint
However the liquidity constraint stops the household from borrowing against their period two
income which will kink the budget line from YEBX to YEC1. This occurs at point E because
the individual cannot borrow to increase their period one consumption and as such they
cannot have any more disposable income in period one. The highest possible indifference
curve that the household could reach is curve U1 which is tangential to the budget constraint
at point E. They cannot be made any better off as they cannot borrow to reach a higher
indifference curve, and if they saved their period one income they would be worse off as they
would be on a lower indifference curve. Therefore the household has chosen to consume at
point E, which means that they will be consuming all of their period one disposable income
in period one.
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3. Student number: 557699
C2
Y
C2=Y2-T2 E
C 2’ B
U’
U1
C1
C1=Y1-T1 C1’ X
From looking at the two consumption points B and E, it is clear to see that the liquidity
constraint is making the household worse off as they are now consuming on a lower
indifference curve U1<U’.
If the government decided to implement a bond-financed reduction in period one taxation
which would be followed by an increase in period two taxation such that the taxes are now
and
The new intertemporal budget constraint is given by
This new budget constraint is exactly the same as the original before tax reduction budget
constraint as the B’s cancel out. Therefore the budget constraint does not move or shift.
However, the endowment point shifts down and to the right along the budget line as period
one income increases whilst period two income reduces.
We can see the effects of this bond financed tax reduction on the next graph and we will
consider two separate situations (1) a small reduction in taxation, and (2) a larger reduction in
taxation.
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C2
Y
E E’
C2*=Y2-T2*
C2’ B
’
U’U*
E’’ U1
C1
C1 C1* C1’ X
’
First we can examine the effects of a small reduction in period one taxation.The original
endowment point E is now shifted to the right to point E’, which has a higher period one
income and lower period two income than the original endowment point. This household
would still prefer to borrow in period one if there was no liquidity constraint, however
because of this constraint they will use all of their period one income to consume at the new
endowment point E’, on utility curve U*. Because the individual has a preference towards
period one consumption, this situation yields a higher level of utility than before since
U*>U1. Again, to reach a higher indifference curve would mean violation of the liquidity
constraint and they could not save any of their period one income as it would make them
worse off. Therefore the liquidity constraint is still binding in this situation and their
consumption function is and .
The situation is quite different when the government makes a larger tax cut. If the cut is large
enough to shift the endowment point further to the right such that it is to the right of point B,
such as point E’’. In fact any point to the right of the optimum point if there is no liquidity
constraint (point B here), will end up with the household being a saver once there is a
liquidity constraint imposed. From this initial endowment point, the household would
actually save some of their period one income such that they would shift back along the
budget line until point B which is where the utility curve U’ is tangential to the budget
constraint. Therefore, the liquidity constraint is not binding in this situation, as the household
has been able to increase their utility regardless of the liquidity constraint.
The consequences of these findings for Ricardian equivalence are that it is not realistic. In
real life a household is not concerned with the value of their lifetime income; instead they are
most concerned with their current consumption. As such a household who needs to consume
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more than their current income must borrow in order to sustain this consumption. If they are
impaired from borrowing to supplement their current income, the household’s current income
is the only thing which determines their consumption, irrespective of their future income.
We can see how Ricardian Equivalence could breakdown because of liquidity constraints if
we consider a young student who is currently at university with a part time job but who has a
job lined up for when he leaves university which will have a significantly higher income than
he currently earns. This individual may want to borrow against his expected higher future
income in order to smooth his consumption or pay for a holiday. However because of
liquidity constraints, such as imperfect financial markets or asymmetry in the information
between people looking to borrow or lend; this individual cannot secure a loan. Once the
government carries out the bond-financed tax reduction followed by a future tax increase, he
is not likely to increase how much he saves by the same value as the tax cut because instead it
will be a relief from his liquidity constraint so that he can consume more this period. This
would be against Ricardian Equivalence which expects that savings increase by the same
amount as the tax cut, but it will favour the Keynesian viewpoint which expects consumption
to increase. Consequently national savings and the government’s current account would
decline in value because of both government savings reducing and no change in private
saving.
Therefore when a bond financed tax reduction is implemented, households will have higher
current income and current consumption even though their future income will be reduced.
This means that the government is essentially giving the household a loan because of the
lower current tax and higher future taxes.
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