A Two-Period Model:

A Competitive Equilibrium and Ricardian

Equivalence
Motivation: Macroeconomic models and their use

• Economic models help economists to

– Understand how the economy works
– Make predictions about future economic behaviour
– Design policies to improve the welfare

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 Learning objectives

• Define and solve a dynamic general equilibrium model with

– Multiple consumers
– Government
– Exogenous production
• Use the model to analyze economic effects of fiscal policy

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Outline

• Discuss key elements of the Canadian fiscal policy.

• Describe how the government’s fiscal policy can be
modeled in the two-period model.
• Define and analyze a competitive equilibrium.
• State the Ricardian Equivalence Theorem.
• Explain the Ricardian Equivalence Theorem graphically
and in numerical examples.
• Give examples when the Ricardian Equivalence Theory
can break down.

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Fiscal policy

• Fiscal policy generally refers to the government’s

choices over its expenditures, taxes, transfers, and
borrowing.
• In Canada, fiscal policy decisions are taken at the
– Federal (national) level;
– Provincial (regional) level;
– Municipal level.

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Savings, deficit and surplus

• Government savings is the difference between

government incomes (tax revenues T less transfers TR
less interest on the government debt INT) and
expenditures G.
S  T  TR  INT  G
g

• Government saving is the government surplus.

• Government deficit is the negative of government
savings (government outlays minus government
receipts).

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Government debt
• The government debt is the accumulated government
deficit.
• The federal debt is related to the federal government of
Canada.
• The total government debt includes federal debt + debt
obligations of the Canadian provinces, territories and
municipalities.
• When the government accumulates debt by borrowing from
its citizens, then this is debt that we as a nation owe to
ourselves.

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Who manages government debt?
• The Department of Finance Canada
The Honourable
manages the federal debt. Chrystia Freeland
has been Canada's
• This ministry issues three types of debt- Minister of Finance since
August 2020.
raising instruments:
– Treasury bills for short-term finance;
– Government bonds for long-term finance;
– Savings bonds for the retail market
• Each province of Canada raises its own
debt through debt instruments.
• “National debt clock” provides a number of interesting
statistics about Canada’s government debt
https://www.nationaldebtclocks.org/debtclock/canada

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Federal government budget at glance April-July 2019
“The Fiscal Monitor” publication of the Department of Finance

Source: https://
www.canada.ca/en/department-finance/services/publications/fiscal-monitor/2019/06.h
tml
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Federal government budget at glance April-July 2020
“The Fiscal Monitor” publication of the Department of Finance

• For the April to July period of the 2020–21 fiscal year, the
government posted a budgetary deficit of $148.6 billion,
compared to a deficit of $1.6 billion reported for the same
period of 2019–20.
• “The unprecedented shift in the government’s financial
results reflects the severe deterioration in the economic
situation and temporary measures implemented through
the government’s Economic Response Plan to support
Canadians and businesses facing hardship as a result of the
COVID-19 outbreak during this period”

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Federal government budget at glance April-July 2020
“The Fiscal Monitor” publication of the Department of Finance

Source: https://
www.canada.ca/en/department-finance/services/publications/fiscal-monitor/2020/07.ht
ml
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Federal government budget at glance April-July 2020
“The Fiscal Monitor” publication of the Department of Finance

• For the April to July periods of the 2020-21 fiscal year,

• Revenues were down $38.3 billion, or 34.1 per cent,
primarily reflecting lower tax revenues and other revenues.
• Program expenses were up $111.1 billion, or 106.2 per
cent, largely reflecting transfers to individuals and
businesses under the Economic Response Plan, including
– the Canada Emergency Response Benefit (CERB),
– the Canada Emergency Wage Subsidy (CEWS), and
– the 25 per cent incentive for the Canada Emergency Business
Account (CEBA). 

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Total government surplus in Canada
(as a percentage of GDP)

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Canada’s position towards government deficits
has varied over time
• See a supplementary reference

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What are the economic consequences of
government deficits?
• Popular conceptions of household finance suggest that
accumulating debt is bad. Does this logic apply to
government debt as well?
• The answer to this question depends on the source of
the deficit:
– Lower taxes?
– Higher spending?
• We will focus on the first source today, and examine the
consequences of higher government spending later in
the course.

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Effects of cutting taxes while keeping government
spending constant
• A current tax cut leads to a government deficit.
• The government must issue new debt.
• The accumulated debt will have to be paid of ultimately
by higher future taxes.
• By running a deficit the government redistributes the
tax burden from one group of citizens to another.
– If the groups are the same: running a deficit will have no
effects on economic activity (the Ricardian equivalence
theorem);
– If the groups are different: Ricardian equivalence may fail.

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Modeling fiscal policy in a dynamic model

• Recall how definition of government surplus

S  T  TR  INT  G
g

• In our model, there is no money and all fiscal variables

are expressed in terms of consumption goods.
• Exogenous expenditures: G
• Taxes T : lump-sum taxes, imposed on consumers
• Transfers TR : absent
• Government savings Sg
• Interest payments: r Sg

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Modeling fiscal policy in a dynamic model: details

• In the current period, the government

– Purchases G units of consumption goods (public good)
– Collects taxes T
– Issues bonds B. Note that B = -Sg.
– If B>0, the government borrows from the public.
• In the future period, the government
– Purchases G’ units of consumption goods.
– Collects taxes T’
– Repays debt / collects interest, (1+r) B.
– No new debt can be issued.
• The government takes G and G’ as exogenous, but chooses T,T’, B.
• No uncertainty, no risk, no government default,

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Government budget constraints

•  Dynamic constraints:
– Current period G = T + B
– Future period G’+(1+r) B = T’

• The present-value (intertemporal) budget constraint:

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Two-period economy with government

• Two periods: the current and the future periods

• m consumers
• Each consumer i has
– Preferences: U(c(i), c’(i))
– Endowments: (y(i), y’(i))
and pays lump-sum taxes (t, t’),
• Taxes are the same across all consumers
• Government and consumers interact on the credit
market, with the real interest rate r

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Competitive equilibrium

• A competitive equilibrium is a state of the economy in

which prices and quantities are such that the behaviour
of all price-taking economic agents is consistent with
each other.
• ‘Competitive’: all agents take market prices as given
• ‘Equilibrium’:
– All markets clear or
– Quantity demanded equals quantity supplied in each and
every market

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Which conditions must hold in the competitive
equilibrium in the dynamic model?
• All agents optimize, given the market prices
– The representative consumer must solve the utility
maximization problem, given the real interest rate rate.
– The intertemporal government budget constraint is satisfied

• The market prices adjust so that all markets clear

– The credit market clears.
– The goods market clears.

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Competitive equilibrium (CE)

Each consumer is optimizing The credit market clears.

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Recall: Each consumer solves the utility
maximization problem
. •MRS
  c,c’ = 1 + r
c’ = - (1+r) c + (1+r) we

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Aggregate identities

• Aggregate endowments
Y = Σ y(i) Y’= Σ y’ (i)
• Aggregate consumption
C = Σ c(i) C’= Σ c’ (i)
• Aggregate private saving
Sp = Σ s(i)
• Aggregate taxes
T= m t T’ = m t’

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Competitive equilibrium

• A competitive equilibrium is allocations c(i), c’(i), s(i), t, t’, T, T’, B,

Sp , C and the real interest rate r, such that for any endowments
y(i), y’(i) and government purchases G and G’ the following
conditions are satisfied:
– Given r, each consumer i chooses c(i), c’(i), and s(i)
optimally
– The government’s present-value budget constraint holds
– The credit market clears: Sp = B

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The credit market equilibrium condition

• Total private savings is equal to the quantity of

government bonds issued in the current period.
Sp = B
• The real interest rate adjusts to guarantee that the
credit market equilibrium.
• By the Walras’ law, the goods market will also be in
equilibrium. Put differently, C+G =Y becomes the
income-expenditure identity.

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Competitive equilibrium (CE)

Each consumer is optimizing The credit market clears.

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Numeral example of the competitive equilibrium

• The next slide provide a partial description of the

equilibrium of the model. That is, the values of some
variables are omitted from the description.
• Your task is to find the values of the missing variables,
by using the equilibrium conditions.

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WORKSHEET: Numerical example of CE

• The number of consumers: m=500

• All consumers are identical
• Endowments: y = 10, y’=12
• Taxes : t = 3, t’ = 4
• The equilibrium real interest rate: 5%
• Equilibrium allocations: c=6, c’=9.05
– Think of these values as outcomes of the consumer’s
optimization!
• Government expenditures: G=2,000, G’=1,475

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WORKSHEET: Numerical example of CE
The government in the current period

• How are the government expenditures financed?

• In the current period, what are the values for

– Total taxes T?

– Government debt B?

– Does the government save or borrow? Why?

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WORKSHEET: Numerical example of CE
The government in the future period

• In the future period, what are the values of

– Government debt payment ?

– Total expenditures?

– Total taxes T’ ?

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WORKSHEET: Numerical example of CE
The consumer’s choice
• Recall that all consumers are identical.
• Find the value of the life-time wealth for the
representative consumer, we.

• Find the level of savings s for each consumer

• Does the representative consumer save or borrow?

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WORKSHEET: Numerical example of CE
The competitive equilibrium
• Let’s verify that the numbers correspond to the
competitive equilibrium

1. Is each consumer optimizing?

2. Is the government budget constraint satisfied?
3. Does the credit market clear?

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Competitive equilibrium (CE)

Each consumer is optimizing The credit market clears.

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The Ricardian equivalence theorem
• If current and future government spending are held
constant, a change in current taxes with an equal and
opposite change in the present value of future taxes
leaves the equilibrium real interest rate and the
consumptions of individuals unchanged.

• A tax cut merely increases savings by consumers, which

just matches the increase in borrowing by the
government.

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The intertemporal budget constraint is the key
equation for understanding Ricardian equivalence
• The consumer’s lifetime tax burden is equal to the
consumer’s share of the present value of government
spending.
t' 1 G' 
t  G  
1 r m  1 r 
• The timing of taxation does not matter for the choice of
consumption. The resent value of government spending
does.

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The Ricardian equivalence theorem (continued)
• The Ricardian Equivalence Theorem can be illustrated
– Algebraically;
– Numerically,
– Graphically.

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Ricardian equivalence

• Keeping the present value of expenditure constant,

consider the following government policy
– Decrease taxes by ∆t in the current period
– Issue extra bonds to finance the expenditures

• In the future period taxes must increase by -∆t(1+r),

to keep the expenditure levels unchanged

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Ricardian equivalence with a cut in current taxes

A lender

Note: Figure 9.16 in the textbook has an

error. The graph corresponds to the case
of a borrower and not a lender

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Ricardian equivalence and the credit market
equilibrium

Assume:
• The substitution effect
from higher interest rate
is greater than the
income effect
• Sp>0

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Why is there no effect on consumption
allocations?
• The consumer’s budget constraint remains the same, as
the present value of taxes is unchanged
• The MRSc,c’ is independent of fiscal policy, as the Euler
equation is not affected by taxes
• Each consumer chooses exactly the same consumption
allocations (savings increases by the amount of
government debt)
• The credit market remains in equilibrium

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Return to the numerical example of CE
(computed last class)
• The number of consumers: m=500
• All consumers are identical
• Endowments: y = 10, y’=12
• Taxes : t = 3, t’ = 4
• The equilibrium real interest rate: 5%
• Initial equilibrium allocations: c=6, c’=9.05, s=1
• Government expenditures: G=2,000, G’=1,475
• Government taxes: T=1,500 and T’=2,000
• Government debt: B=500

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Numerical example of Ricardian equivalence (RE)

• Consider the following government policy: reduce taxes

for each consumer in the current period, with an
offsetting increase in the future tax rate t’.
• The new tax is t =2.
• What are the impact on this policy on the competitive
equilibrium?

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Numerical example of RE (continued)

• To analyze the effect of this fiscal policy on the

competitive equilibrium, we’ll take a 2-step approach:
– Assume that the real interest rate remains at
unchanged at r=5%.
– If we are able to verify that all equilibrium conditions
are still satisfied with this interest rate, then our
assumption is correct and r=5%.

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Numerical example of RE (continued)
Taxes and bonds under the new tax policy
• How are the government expenditures financed
under the new policy?
• Compute the values of fiscal indicators
• In the current period:
– T, G and B
• In the future period:
– (1+r)B, under the assumption that r=5%, T’ and t’

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Numerical example of RE (continued)
Taxes and bonds under the new tax policy
• In the current period:
– T=
– G=
– B=
• In the future period:
– (1+r)B =
– T’ =
– t’ =

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Numerical example of RE (continued)
Summary information
• c =6, c’=9.05
• Compute the savings s
• r=5%
• t = 2, t’=5.05
• T=1,000, T’=2,525
• B = 1,000

• Let’s verify that these numbers correspond to a

competitive equilibrium

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Numerical example of RE (continued)

1. Each consumer is optimizing – verify that the consumer’s

intertemporal budget constraint holds

2. The government’s budget constraint is satisfied:

2,000 + 1,475/1.05 = 1,000 + 2,525/1.05
3. The credit market clears:
Private saving = 500 x 2 = 1,000
Government debt = 1,000

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When can make Ricardian equivalence fail?

• Distributional effects across individuals at a point in

time.
• Distributional effects across generations.
• Taxes are distortionary.
• Credit market imperfections.

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Summary

• The Ricardian equivalence theorem states that changes in

current taxes that leave the present value of taxes constant have
no effect on consumption and the real interest rate.
• Ricardian equivalence critically depends on the idea that the
burden of the public debt is shared equally among the people
alive at the time the debt is issued.
• The burden of the debt is not shared equally when:
– There are current distributional effects of changes in taxes
– There are intergenerational distribution effects
– Taxes cause distortions
– There are credit market imperfections

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