Consider a two-period representative-agent economy. Agents live for two periods
ID: 1186358 • Letter: C
Question
Consider a two-period representative-agent economy. Agents live for two periods (t=0. 1) and then die. Each agent is endowed with a ''free". A tree yields output (dividend) ytto its owner at the beginning of period t. Output is perishable, while trees are perfectly durable. An agent can issue shares on his tree and sell these shares to other agents in the asset market. In general, let St be the share of trees which the representative agents has at the beginning of period t. Let at be the period per share of a tree after dividend payments. Note that there is no currency in the economy and transactions are directly in terms of goods. There is government in this economy too. The government spends gt in period t and these amounts are exogenously set and are expressed in per-capita terms. To finance its spending, the government can either levy a lump-sum tax rt (t=0, 1) or issue one-period real bonds in period 0. Letb1 be the be the quantity ( per capita ) of government bonds sold in period 0 and q0 be unit price of such bonds. Write the government's budget constraints in period 0 and 1. (2 mark) Write the representative agent's budget constraints in 0 and 1. (3 mark) Write the representative agent's maximization problem, set up the Lagrangian and then find the optimality conditions of choices (C0, C1, S1, S2, b1) Explain the economic meaning of the optimality condition of b1 Solve the equilibrium allocations ((C0, C1, S1, S2, b1) and equilibrium prices (a0, q0) How is the bond price q0 affected when the supply of bonds increases? Explain briefly. What is Ricardian Equivalence? Does it hold in the current model? Explain briefly.Explanation / Answer
Definition of 'Ricardian Equivalence' An economic theory that suggests that when a government tries to stimulate demand by increasing debt-financed government spending, demand remains unchanged. This is because the public will save its excess money in order to pay for future tax increases that will be initiated to pay off the debt. This theory was developed by David Ricardo in the nineteenth century, but Harvard professor Robert Barro would implement Ricardo's ideas into more elaborate versions of the same concept. Also known as "Barro-Ricardo equivalence proposition" Investopedia explains 'Ricardian Equivalence' The basic idea behind Ricardo's theory is that no matter how a government chooses to increase spending, whether with debt financing or tax financing, the outcome will be the same and demand will remain unchanged. The major arguments against Ricardo's theory are due to the unrealistic assumptions on which the theory is based, such as the assumptions of the existence of perfect capital markets, the ability for individuals to borrow and save whenever they want, and the assumption that individuals will be willing to save for a future tax increase even though they may not see it in their lifetimes. Furthermore, the theory provided by Ricardo goes against the more popular theories provided by Keynesian economics. refer to this link http://www.google.co.in/url?sa=t&rct;=j&q;=ricardian equivalence example&source;=web&cd;=1&cad;=rja&ved;=0CC8QFjAA&url;=http://www.hull.ac.uk/php/ecskrb/ECOMOD/RicardianEV.pdf&ei;=KL5hUdH_IIKlrQfFwIGgBA&usg;=AFQjCNGW8Z_a4paz1sDFi06B85FKrYUqkg&bvm;=bv.44770516,d.bmk 11 Limitations of Ricardian Equivalence Theorem Why was there a big concern on accumulation of public debt in 1970 and early 1980s? Also to debt accumulation in many developing economies? By Ricardian Equivalence private saving rises against an increase in the public sector deficit. If private sector saving compensates for public sector deficit then there is no alteration in national saving in response to public debt. There is no crowding out between public and private sector. This does not hold when private agents face inter generational borrowinglending constraint or if it takes long time for government to increase taxes to repay debt. By choosing deficit financing by borrowing government is promoting inter generational transfers because current debts may be paid by taxing people in the far distant future generation. Main issue in this intergenerational transfer is that how many people save for their children, grand children or grand-grand children? for proper answer