Government Debt, Life-Cycle Income and Liquidity Constrains: Beyond Approximate Ricardian Equivalence


Government Debt, Life-Cycle Income, and Liquidity
Constraints: Beyond Approximate Ricardian Equivalence
by Hamid Faruqee, Douglas Laxton, and Steve Symansky

The effects of government debt on the real interest rate, or the degree to
which government deficits crowd out private-sector economic activity, depend to
a large extent on whether consumers view debt as net wealth. If consumers are
connected to all future generations and can borrow and lend against their
future income streams, changes in debt will not crowd out private consumption
and investment because consumers effectively internalize the government's
intertemporal budget constraint and regard a debt-financed reduction in taxes
today as implying an equivalent increase in future tax burdens. This extreme
polar case is generally referred to as the Ricardian equivalence hypothesis.

This paper uses an extended version of Blanchard's finite-horizon model to
re-examine the validity of the Ricardian equivalence hypothesis. The model has
been used extensively to study fiscal policy issues because it captures the
essential intertemporal aspects and gives rise to well-defined steady-state
properties. It has been demonstrated that although agents are disconnected from
future generations in the model, the model obeys approximate Ricardian
equivalence; debt financing has very small effects on the equilibrium real
interest rate and capital stock.

As the paper shows, incorporating more realistic individual lifetime income
profiles and liquidity constraints into the Blanchard model can significantly
change estimates of the long-term implications of government debt. OECD
estimates of aggregate net public debt for 18 of the largest industrial
countries show an increase of about 20 percentage points in the debt-GDP ratio
since the late 1970s. The model developed in this paper suggests that this
increase in government debt has caused an increase in the world real interest
rate of 76 basis points and a permanent reduction in world real GDP of 2.9