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Macroeconomic Analysis 2003

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  1. Macroeconomic Analysis 2003 Fiscal Policy 2: Ricardian Equivalence Theorem And Inflation Tax Lecture 15

  2. Contents • Main point of the Ricardian Equivalence Theorem (RET) • Graphical and Algebraic Illustration of RET • Numerical Example of RET • Limitations of RET • Deficit financing by printing money:Seigniorage • Optimal Inflation tax rate • Why governments like inflation tax? • Dangers of excessive inflation Lecture 15

  3. Ricardian Equivalence: Main Proposition • How important is a tax cut? • Should government finance deficit by borrowing or by raising taxes? • Ricardian Equivalence Theorem is after David Ricardo. • British economist, who wrote about 180 years ago that it does not matter whether government finances its deficit by • borrowing or • taxes. Lecture 15

  4. Ricardian Equivalence: Main Proposition • If it borrows now it raises tax in future for repayment of its debt. • With more current debt private households save more in anticipation of higher taxes in the future that government will impose on them to repay the debt. • Private households optimise intertemporally and completely internalise public policy. • Borrowing only or tax only strategy does not matter if both the government and household honour their own inter temporal budget constraints. Lecture 15

  5. Basic Proposition of the Ricardian EquivalenceTax or Borrowing Does not Make Any Difference Tomorrow C2 Before Borrowing Budget Constraint After borrowing budget constraint C1 Today Lecture 15

  6. Model Economy for Ricardian Equivalence Theorem Lecture 15

  7. Tax Spending and Borrowing Strategies Lecture 15

  8. Optimisation for Ricardian Equivalence Theorem Lecture 15

  9. Conclusion of the Ricardian Equivalence Theorem Lecture 15

  10. Numerical Proof of Ricardian Equivalence Theorem -1 Lecture 15

  11. Borrowing strategy: period 1 borrowing of 30 Lecture 15

  12. Limitations of Ricardian Equivalence Theorem Lecture 15

  13. Deficit Financing by Printing Money Lecture 15

  14. Inflation Tax: A Numerical Example Lecture 15

  15. Lecture 15

  16. Lecture 15

  17. Exercises • Does it make difference if the deficit if financed by more taxes or by more borrowing? • Proof of Ricardian Equivalence • Household utility with and without public goods • Implications of borrowing from the private sector or the central bank • How does inflation tax reduce the debt burden for governments? Lecture 15