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An Investigation of Ricardian Equivalence in a Common Trends Model

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  • Becker, Torbjörn

    (Department of Economics)

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    Abstract

    A common trends model for grow national income, private consumption, government consumption and net taxes is estimated on US data. The system has two cointegrating vectors and thus two common stochastic trends, interpreted as a technology trend and a public sector trend. The two temporary shocks are interpreted as a private demand and government financing shock, respectively. Theoretical models suggest that the two cointegrating vectors could be due to the private and public sectors' intertemporal budget constraints. We find two co-integrating vectors, as predicted by no-Ponzi game constraints on the sectors. However, a stronger version of the no-Ponzi game constraint is a solvency condition, which implies particular co-integrating vectors. These cointegration vectors are both rejected for the sample period, indicating that the public sector will not be able to repay its debt if the current policy is maintained. However, the private sector is at the same time accumulating wealth, which is consistent with predictions from a Ricardian model. Further, the equivalence theorem pridicts that private consumption should be unaffected by financing shocks. Data, however, indicate that there is a significant short run effect on both income and private consumption from the financing shock, but the effect indicates that increasing taxes is accompanied by increasing private consumption, contrary to both standard Ricardian and Keynesian models. In the theoretical world, this type of pattern could be generated in models with risk averse individuals and uncertainty about future taxes.Abstract:

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    Bibliographic Info

    Paper provided by Stockholm School of Economics in its series Working Paper Series in Economics and Finance with number 72.

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    Length: 42 pages
    Date of creation: Oct 1995
    Date of revision:
    Publication status: Published in Journal of Monetary Economics, 1997, pages 405-431.
    Handle: RePEc:hhs:hastef:0072

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    Postal: The Economic Research Institute, Stockholm School of Economics, P.O. Box 6501, 113 83 Stockholm, Sweden
    Phone: +46-(0)8-736 90 00
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    Keywords: Public debt; private consumption; sustainability; cointegration;

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