THE traditional, perhaps still predominant view of fiscal policy holds that, in a closed economy, all government expenditures—regardless of their use or method of financing—affect aggregate demand with a multiplier of at least as great as unity. According to this view, fiscal policy has effects on the real sector and is an important tool not only for stabilization but also for generating growth. This traditional approach, however, is based in large part on assumptions that imply asymmetric perceptions of fiscal policy variables on the part of the private sector (Kormendi (1983)). Consumers are assumed to discount current taxation fully in making their consumption (or saving) decisions, since these consumption decisions are a function of disposable income, which is defined to be current after-tax income. Future taxation that may be implied by the financing needs for the servicing and retirement of current debt is, however, assumed to have no effect on consumer decisions. Consequently, consumers regard current spending that is not financed by current taxation but by debt accumulation, the servicing of which could imply future taxation, differently from current spending that is financed by current taxation alone. Private sector consumption decisions, according to this view, are thus sensitive to the financing decisions of the government. Even when the expected tax implications of tax and debt financing for a given path of government expenditures are the same in present-value terms, the level of private sector consumption would be different when debt financing rather than tax financing is used by the government. The level of private sector consumption would be reduced with increases in current taxation but would be insensitive to increases in the current debt of the government.
Even in a forward-looking analysis using future disposable income that includes some notion of anticipated taxation, in general the stock of government debt in private hands continues to be regarded as part of private wealth. In either case the implicit assumption that is made is that households (or the private sector) are unable to perceive the future tax implications of a current expansion in government debt. Consequently this view subscribes to systematic errors in private sector perceptions of government fiscal policy. In this manner private sector perceptions are not viewed to be rational.
The traditional view in essence ignores the intertemporal budget constraint of the government, which requires the difference between the present value of all expected taxation in the future and the present value of the path of expected government expenditures to be equal to the current stock of government debt. Viewed in this manner, any increases in the current stock of government debt would, for a given path of future government expenditures, require an increase in taxes in the future for the servicing and retirement of the additional debt incurred today. An increase in current government debt therefore represents merely a shift in the timing of tax collection from the current period to the future. To the extent that the future tax implications of this shift are not fully perceived by the private sector, there will be a net wealth effect leading to an increase in consumption and, hence, to a decline in saving. Eventually this decline in saving should translate into a slower rate of capital accumulation and growth. If, however, the future tax implications of current government spending are fully perceived, current saving would be increased to allow for the anticipated taxation. Bequest motives for saving to provide for the perceived tax in future generations could lead to a situation in which the expected taxation is fully discounted for in the present period.1 Saving would thus increase to provide for this tax need in the future. Private consumption would then decline by the full extent of the increase in government debt, leaving aggregate demand unaffected. Government debt would therefore be absorbed in the economy without any real effects.
The proposition that a given level of government expenditures may be financed either by taxation or by debt accumulation with equivalent real consequences is due to David Ricardo and has therefore come to be known as Ricardian equivalence. This equivalence proposition has received a great deal of attention in recent years because of the prevalence of large deficits in developed as well as developing countries. Large fiscal deficits in industrial countries are thought to have contributed to the persistence of high real interest rates, while at the same time large fiscal deficits in developing countries have served to increase external indebtedness in these countries. As external financing became scarce, earlier in this decade the latter group of countries were required to reduce their fiscal deficits to bring them more in line with available financing. This required reduction in fiscal imbalances has rekindled an interest in the possibility of an additional contractionary effect at a time when the external financing constraint has already adversely affected growth. For the regeneration of growth in these countries in the coming period when external financing is likely to remain severely limited, it would be important to determine whether the needed increases in fiscal savings would help improve domestic resource mobilization. If Ricardian equivalence holds, total saving would remain unchanged in the face of increased public savings.
Barro (1974) revived the equivalence proposition by arguing that individuals, because of their concern for their children, would provision for future taxation when making their current consumption decisions. Even if increased taxation in the future was not expected in their lifetimes, strong altruistic feelings for their children would impel individuals to leave bequests to meet such tax needs. Such individuals will therefore behave as if they were “infinitely lived” and will make their consumption decisions taking into account the intertemporal budget constraints of the government. Recently, Blanchard (1985) noted that the planning horizons of the government and individuals may not be the same if individuals recognized the possibility of death or dynastic extinction. In this case, the individual discount rate may be higher than that of the government, leading to current taxation being treated differently from future taxation. Because of its apparent plausibility the Blanchard approach to modeling deviations from equivalence has received considerable attention in the literature and has also been applied to saving behavior in developing countries (see Buiter (1986)). There have been only isolated attempts, however, to test empirically the Blanchard hypothesis. The purpose of this paper is to specify and estimate a rational expectations model of saving in developing countries, focusing on the hypothesis that planning horizons of the government and the private sector are different.
The rest of the paper is divided into three sections. A review of the literature in Section I sketches the factors that could lead to a deviation from equivalence and notes the results of some of the tests that have been conducted for the United States.2Section II develops an empirical version of the Blanchard model, which has recently been acquiring prominence in this literature, in a rational expectations setting.3 The results of the rational expectations model are presented in Section III, and conclusions are offered in Section IV.
I. Do Fiscal Deficits Matter?
The Ricardian equivalence proposition suggests that the method of financing a given path of government expenditures has no important real consequences. Because the issuance of new debt is associated with anticipation of future taxation in the perceptions of rational agents, debt financing or maintaining a balanced budget to finance a given path of expenditures would have equivalent effects on aggregate demand. In other words, because of the anticipated taxation implied by increases in public debt, the substitution of debt for taxes would leave private sector wealth and consumption unchanged. Debt financing in private sector perceptions is, therefore, only a shift in the timing of tax collection. As such, the change in the timing of tax collection would leave private sector wealth and consumption unchanged, provided that the present value of the stream of taxation that the alternative modes of financing imply is equivalent (Barro (1974, 1978) and Leiderman and Blejer (1988)).
The equivalence proposition is, however, based on certain assumptions that, when relaxed, not surprisingly lead to deviations from equivalence. The key assumptions for obtaining Ricardian equivalence are the existence of perfect capital markets with no borrowing constraints, a tax structure that is nondistortionary, no uncertainty about future taxation and expenditures, and identical planning horizons for the private and public sectors.4Hayashi (1985) has shown that, although borrowing constraints may be an important source of deviation from equivalence, these constraints do not necessarily lead to such deviations, and Ricardian equivalence can hold despite them.
A necessary condition for the equivalence proposition to hold is that households and the government have the same planning horizons and use the same discount factors in their present-value calculations. Barro (1974) showed that the concern of individuals for future generations would induce behavior similar to that which would obtain if individuals were infinitely lived. A strong bequest motive would, therefore, ensure that the planning horizons of both individuals and governments, or society at large, were infinite. These infinitely lived individuals would recognize in their decision making that eventually the accumulated government debt must be repaid.
Blanchard (1984, 1985) has proposed that the probability of death or dynastic extinction could result in effective private sector subjective discount rates that exceed the pure rate of time preference, and in effective private sector market discount rates that exceed the government interest rate. In particular, private human wealth is discounted differently from nonhuman wealth because human wealth dies with the individual. In this case, a shift in the timing of taxation toward the future could have real consequences owing to the higher and differential discounting of the future by the private sector. This model has as yet been subjected to only limited empirical testing;5 and here we are able to test this model for 16 developing countries.
Empirical testing of the Ricardian equivalence hypothesis has been carried out mainly for the industrial countries.6 The empirical approach that has been used has, however, not been based on any explicit optimizing model of consumer behavior. Attempts to test the hypothesis have instead relied on the introduction of government variables in the consumption function and have judged the relevance of Ricardian equivalence on the basis of sign and significance of the coefficients obtained. The assumptions of the equivalence proposition as a result have not explicitly been tested. The general approach used has been to include fiscal deficit variables in a regression of private consumption on income and wealth to test if the alternative methods of financing have the same effects on private consumption. Although the equivalence argument is based primarily on expectations of future fiscal behavior, no attempts have been made to incorpoate explicitly anticipated fiscal variables or expectations behavior into the estimating model. Perhaps for these reasons the accumulated empirical evidence remains inconclusive. Although Barro (1978), Kochin (1974), Kormendi (1983), Seater and Mariano (1985), and Tanner (1979) have reported evidence supporting the Ricardian equivalence proposition, Blinder and Deaton (1985), Feldstein (1982), Modigliani (1987), and Reid (1985) have provided evidence against equivalence.
Testing the Ricardian proposition in the context of a dynamic optimizing framework is a recent approach. Leiderman and Razin (1986), in an approach similar to that of this paper, estimated a version of Blanchard’s (1985) model using monthly data for Israel. Their tests provide evidence against Blanchard’s hypothesis of different planning horizons for the government and private citizens, and therefore in support of Ricardian equivalence. The only other attempt at empirically testing the Blanchard-Yaari model has been made by van Wijnbergen (1986).7 Recognizing that the Blanchard-Yaari approach in essence implied that the discount rates of the private sector and the government were different, van Wijnbergen tested for such differences among member countries of the Organization for Economic Cooperation and Development (OECD). The results of this test, which also assumed static expectations, suggested strong support for the Blanchard-Yaari approach.
II. A Model of Fiscal Policy and Private Saving
The Blanchard-Yaari approach assumes that individuals, because of their finite and known probability of death (or survival), have a planning horizon that is different from that of the government, which represents the society at large. Society at large has an infinite horizon for its decision making, but individuals recognize the mortality of their planning horizons. The finiteness of life could be interpreted more broadly, as a possibility of dynastic extinction (Buiter (1986)). Barro’s (1974) hypothesis that bequest motives could lead individuals to behave as if they were infinitely lived—and therefore to a situation in which government debt was fully discounted and complete Ricardian equivalence prevailed—may not hold if individuals recognize this probability of dynastic extinction. Blanchard (1984, 1985) has shown that this finiteness of individual lives results in an effective discount rate for human capital, which dies with the concerned individual, that is higher than the discount rate for nonhuman wealth, which lives on. This difference in discount rates implies nonneutrality of debt and deficits.
In each time period it is assumed that a new generation is born while each existing generation faces a probability of death (or survival). Thus, although the size of the older generation is constantly being reduced, a new generation is being added each period. Consequently, in the model there are overlapping generations of finitely lived individuals. Denoting the consumption of an individual of age a at time t by ca, r and using a constant relative risk aversion utility function, one may write utility in period t as8
where δ denotes the subjective discount factor and θ is the reciprocal of the intertemporal elasticity of substitution σ (that is, θ = 1/σ).
In each period, each individual is assumed to face a known probability of survival denoted as γ, which, for mathematical convenience, is assumed to be independent of age. Thus the probability that an individual survives k periods is γk. Expected utility in period t is therefore the discounted sum of expected utilities in the future:
From Blanchard (1985), it is assumed that insurance companies exist that at the time of death cover outstanding debt while assuming the estate. Competition among insurance companies ensures that the insurance premium equals 1 − γ. Given a constant interest rate denoted r, the effective borrowing rate in the presence of the probability of death and the insurance arrangement is (1 + r)/γ.
If there are no constraints on borrowing, the lifetime budget constraint can be written as
where α = 1/(1 + r); wa,0 denotes the wealth of an individual of age a at period zero; γ is individual earnings; τ is individual taxes; and ba-1.0 denotes the debt incurred (or bonds accumulated) by individuals at age a − 1 and in period zero.
In deriving this budget constraint, the solvency requirement has been used whereby at the limit, as k approaches infinity, the present value of the debt commitment is zero; that is,
Equation (3) suggests that current wealth consists of two components: human wealth, which is the discounted sum of the future stream of disposable incomes, and financial or nonhuman wealth equivalent to interest plus the repayment of principal or past debt commitments (which may be negative or positive). Because human wealth is specific to the individual, it disappears from the system when the individual dies. But because of the insurance mechanism, financial wealth is retained within the system. The two types of wealth are therefore discounted differently.
The individual’s problem is to maximize the discounted sum of lifetime expected utility (2) subject to the lifetime budget constraint (3). The following consumption function is derived from this maximization:
with s defined by
Because there are overlapping generations of individuals in this society, to derive the aggregate consumption function one must determine the size of each cohort and sum across all cohorts. Normalizing the population such that at birth each cohort consists of one individual who is assumed to be born without debt, the size of each cohort of age a is γa. Thus in each period there are γa members of the cohort of individuals of age a. The size of the population is therefore a constant given by
Per capita aggregate wealth is therefore the sum of the wealth of all individuals from all cohorts divided by the total population:
In terms of its human and nonhuman components, per capita aggregate wealth can be rewritten as the sum of the value of human wealth in that period, Ht, net of interest and principal payments on past private sector debt,
The per capita value of aggregate human wealth is defined as the discounted sum of the stream of future per capita disposable incomes computed by using the effective (risk-adjusted) rates of interest. Note that, in contrast with the individual budget constraint (3), where the rate of interest applicable to individual debt was the risk-adjusted rate, the rate applicable to per capita national debt in equation (11) is the risk-free rate.
Similarly, aggregate per capita consumption is the sum of the consumption of all individuals from all cohorts divided by the total population:
Aggregate consumption as a function of aggregate wealth may therefore be written as
Using the per capita relationships developed above, one can also derive the economy-wide per capita budget constraint by aggregating individual budget constraints across cohorts for period t:
where Yt denotes per capita real income and Tt is real per capita taxes.
Substituting the definition of per capita consumption, function (13), and the definition of aggregate wealth, equation (9), into the budget constraint (14) yields
With static expectations, per capita human wealth may be written as
Using equation (16) to substitute for Ht and Ht-1 then yields
The result is an estimable form of the consumption function with lagged consumption, current disposable income, and lagged disposable income as independent variables.
At this point it is worth noting three important considerations about equation (19). First, it offers us a convenient specification for testing for Ricardian equivalence. One may rewrite equation (19) as
From the definitions of the parameters it is readily apparent that if β1 is equal to β2, then γ has to be equal to unity, and Ricardian equivalence holds. Alternatively, given adequate data, one could also obtain direct estimates of s, α, and γ by using a nonlinear estimation technique.
Second, with β0 equal to unity and β1 equal to β2, equation (20) reduces simply to the Hall (1978) specification, in which current consumption and last period’s consumption differ only by the extent of the forecast error in current disposable income.9 In the case of static expectations, the forecast error is merely the actual increase in disposable income, since it was expected that last period’s disposable income would be obtained this period.
Third, the only way in which other government variables could be entered in the consumption function is through the tax variable in disposable income. Given static expectations and the assumption of no monetization of deficits, the government budget constraint can be written as
Solving for T in equation (21), one can then substitute the results into equation (20). It must be remembered, however, that the model gives only three parameters to estimate (s, α, and γ). In its contrained form the consumption function with the government budget constraint substituted in will give nothing more than what estimating equation (20) would give. The essential point is that there is no gain to substituting for taxes in equation (20). The parameter γ—or what is more important to testing for the equality of planning horizons, whether γ equals unity—can be implemented using equation (20). Moreover, for the developing economies where data shortages are acute, especially when it comes to an adequate length of reliable time series of fiscal variables, it is certainly advantageous to be able to do without the fiscal variables.
To derive an estimating form that allows for uncertainty and rational behavior, one has to contend with the fact that in a stochastic environment there is no closed-form solution to the consumer’s optimization problem (see Hayashi (1982)). Consequently, following convention, one may posit the stochastic version of the consumption function by adding on an error term to the consumption function derived above (see Hayashi (1982)). The consumption function may therefore be rewritten as
If it is assumed that future disposable incomes are not known, human capital becomes the discounted sum of expected future disposable incomes:
Alternatively, this expression for human capital may be expressed as a stochastic difference equation:
where et is the forecast error in predicting future disposable incomes or the innovations in the income process:
Substituting the consumption function, equation (22) above, into the budget constraint (14), one has
Multiplying the lagged version of equation (27) by α−1, subtracting both sides from Ht, and using the consumption function (22) yields
Equation (29) gives an estimable form of the consumption function that requires only a series for consumption and disposable income; it allows a test of whether there are differences in subjective rates of time preference of the individuals in a society, on the one hand, and of society on the other. Using a nonlinear method, direct estimates of the three parameters of interest—s, α, and γ—could be derived. If interest lies only in testing for differences in planning horizons and not in the parameter estimates per se, however, an easier approach can be followed. Note that the errors in equation (29) follow a complicated autoregressivc, moving-average process. In linear terms equation (29) can, therefore, be written as
Notice that equation (28) allows the test to be conducted using linear rather than nonlinear methods. If in a linear estimation that accounts for the autoregressive, moving-average error process the coefficient of lagged disposable income (n2) is insignificant, it can be inferred that the individual’s subjective probability of survival is unity, and that the differences in the horizons between the government and the citizens cannot be regarded as a source of Ricardian equivalence.10
Another interesting feature of the model that can be seen from equation (28) is that, if the Ricardian equivalence hypothesis is accepted (that is, η2 = 0 or γ = 1), then consumption will turn out to be a function of lagged consumption only. Hall (1978) had proven that, in a rational expectations framework, consumption would be a random walk; that is, would differ from lagged consumption only by a random component. With γ = 1, equation (28) can be rewritten as
which is similar to Flavin’s (1981, 1985) respecification of Hall’s approach with the transitory components of income not equal to zero. Since h =sα−1, reasonable assumptions for the values of s and α would imply a value of θ close to unity, which is similar to that implied by the Hall model.
As discussed earlier, most of the empirical testing of the Ricardian equivalence hypothesis has been done for the industrial countries in the context of a consumption function that was not derived from any optimizing approach. In this section the equations that were derived above under an optimizing approach are estimated for a sample of developing countries. The data were drawn from the World Bank's Economic and Social Database and approximately cover the period 1960–85 (the exact length of the series used for each country is shown in Table 1). The sample consisted of 16 countries: Algeria. Brazil, Cameroon, Colombia, Egypt. Indonesia, Republic of Korea, Malaysia. Mexico, Pakistan, Philippines, Peru. Sudan, Turkey, Tunisia, and Yugoslavia. Other than data considerations, the choice of the sample was determined by the desire to maintain a geographical balance and to obtain a sample that would be representative of various categories of developing countries. Thus the sample contains five African countries, two European countries, four Latin American countries, and five Asian countries. With countries having per capita incomes in 1984 of US$800 or less classified as low-income countries, there are seven low-income countries in the sample and nine middle-income countries (see World Bank (1986)). The sample also contains seven oil exporters.
|[Ct = h0Ct-1 + h1Ct-2+h2(Yt-1-Tt-1) + vt]|
|Korea, Rep. of||1.4||-0.299||-0.O48||0.994||520.08||1960–85|
For each country the dependent variable used is real private consumption. For the independent variable, a measure of labor income and tax revenue is needed. Unfortunately, satisfactory estimates of both variables are not easily available for most of the countries in the sample. Gross revenues were not used because they were in general available only for a period of some ten years, and these figures could not be purged of nontax revenues such as oil revenues. For these reasons it was decided to proxy disposable income by gross national product (GNP) divided by the consumer price index.11
For the estimation of the rational expectations specification (equation (30) above), generalized instrumental variables were used. The instruments are required because the estimating form involves both a lagged dependent variable and a fairly complicated autoregressive, moving-average error process. As required by theory, the instruments were chosen such that they are uncorrected with the residuals and correlated with the dependent variable—private consumption. The instruments that were used were lagged domestic credit to the government and lagged exports, both deflated by the consumer price index, and income lagged by one and two periods. The estimation technique first used ordinary least squares to derive estimates of the errors. These estimates were used to derive an estimate of the error covariance matrix, which was then used to weight the residual sum of squares at the second stage.12
The results for the rational expectations model are presented in Table 1. In general, the fit appears to be reasonable, and the coefficients have the signs that the model predicts. Lagged consumption is significantly different from zero at the 5 percent level and has a point estimate larger than unity for most of the countries, whereas the second lag of consumption, although significant in fewer countries, is negative. The most important result is that the coefficient of lagged disposable income is insignificant in all countries except Mexico. The data therefore provide little support for the Blanchard-Yaari hypothesis of differing discount rates for the private sector and the government.
As pointed out earlier, if γ = 1 (that is, the Ricardian equivalence proposition holds), the Hall (1978) specification of consumption as a random walk is suggested. The results in Table 1 tend to support this specification. In most cases lagged consumption has a coefficient that is significantly different from zero but not from unity, whereas the other variables are insignificant. Only in four cases (Colombia, Mexico, Peru, and Tunisia) does the coefficient of lagged consumption differ from unity. In these cases, however, the second lag of consumption tends to be close to unity, as predicted by the model. To see this, note that the estimating form, equation (29), is merely a differenced version of equation (28), with γ = 1. In this differenced case, the expectation is that the coefficient of lagged consumption will be larger than unity and that the coefficient of the second lag will be negative and close to unity. The empirical results suggest that the Hall specification—with γ = 1 and a coefficient of lagged consumption of 5α-1, which is close to unity—appears to be the correct one.13 The empirical evidence presented here, therefore, does not lend support to the hypothesis that the finiteness of individual lives may be a source of nonequivalence.
The large and growing fiscal deficits of recent years in many countries has generated a renewed interest in the economic consequences of fiscal policy. The earlier, Keynesian notion that an expansion of government expenditures financed by an increase in the stock of debt could have desirable countercyclical and growth effects has been challenged. It is contended that rational economic agents would be able to see that the increase in current debt merely represents a shift in the timing of taxation from the current period to the future. To provide for this anticipated increase in taxation in the future, these consumers will adjust their consumption downward today. In the extreme case, the increase in government consumption may be fully offset by the private sector, thereby leaving aggregate consumption unchanged. The policy of pump-priming the economy by incurring current deficits would therefore not work.
This line of reasoning, which represents a revival of the Ricardian equivalence proposition, basically emphasizes that both bond and tax financing of a given path of government expenditures have equivalent real consequences. Bequest motives would lead individuals to adjust their consumption levels even when anticipated tax changes are expected to occur beyond their lifetimes (Barro (1974)). The recognition of bequest motives in this manner means in essence that infinitely lived households form the basis of economic analysis or, alternatively, that the planning horizons and hence the discount rates of the household and the public sector are the same. A dichotomy may be introduced in the two discount rates, as recently has been done by the explicit recognition of the possibility of death or dynastic extinction (Blanchard (1985)). As a result of this assumption, the planning horizon of the private sector is shortened relative to that of the public sector. Present consumption is then discounted at a higher rate than before. Consequently, anticipated taxation will be treated differently from current taxation.
The notion that a departure from Ricardian equivalence could occur if the planning horizons of the government and the private sector were different has recently received considerable attention in the theoretical literature (Blanchard (1985), Buiter (1986), and Frenkel and Razin (1986b)). Tests of Ricardian equivalence, which have been conducted mainly for the industrial economies, have been rather general in nature and have sought only to confirm or reject the equivalence proposition without attempting to determine the reasons for deviations from equivalence. To enhance understanding of the workings of the economy, as well as the ability to model that behavior, however, it is important to understand the source of the deviation from equivalence. Consequently, in this paper a departure has been made from the usual approaches used to test for Ricardian equivalence. Specifically, the Blanchard-Yaari proposition of finite horizons for consumer planning problems as a source of deviation from equivalence was tested in the context of an optimizing model of consumer behavior in a rational expectations setting.
The results of the empirical tests provide evidence largely in favor of the infinitely lived household. For 15 of the 16 countries in the sample, the null hypothesis of different planning horizons for the private and public sectors was not supported by the data. For these reasons, consumption appears to follow the random-walk specification of Hall (1978), confirming the permanent income hypothesis. Thus, any deviation from equivalence, if observed, would not arise from differing discount rates for the household and the public sector.
Deviations from equivalence, where observed, must therefore arise from other sources. Among these, an important factor to test for is the presence of liquidity constraints. In view of the low income levels and the likelihood of imperfections in the capital markets in developing economies, there is a strong possibility of the existence of liquidity constraints in these economies. Such constraints, by preventing the optimal consumption-savings decisions from being realized, can make present taxation less desirable to households than future taxation. In recent papers, Haque and Montiel (1987) and Rossi (1988) tested for the presence of liquidity constraints in developing economies, to conclude that Ricardian equivalence may not hold in developing economies primarily because of the prevalence of liquidity constraints in these economies. The analysis by Haque and Montiel (1987) also confirmed the results of the present paper, since finite horizons were not supported by the data. Deviations from equivalence in developing countries, therefore, are due to the presence of liquidity constraints, rather than differences in the planning horizons of the public and private sectors.
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Mr. Haque, an economist in the Developing Country Studies Division of the Research Department, holds degrees from the London School of Economics and Political Science and the University of Chicago. He thanks Willem Buiter, Mansoor Dailami, Ricardo Martin, Assaf Razin, Sweder van Wijnbergen, and his colleagues in the Fund for helpful comments and discussions.
See Leiderman and Blejer (1988) for a detailed discussion of the implications of relaxing these assumptions.
The only exception being Leiderman and Razin (1986), who used an approach similar to that of this paper to test for Ricardian equivalence in Israel.
Because Blanchard (1985) used Yaari’s (1965) model of finitely lived consumers to study fiscal policy, the modeling approach used here is interchangeably attributed to Blanchard and to Blanchard and Yaari.
For simplicity, this section does not consider the case of uncertainty but develops only the case of static expectations in the presence of perfect certainty.
Hall (1978) argued that consumption was in essence a random walk; that is, current consumption was expected to be the same as last period’s consumption except for a random element. Flavin (1981), however, correctly pointed out that consumption would be an exact random walk only if the transitory component of income were identically equal to zero. In the specification here, the counterpart of Flavin’s transitory component is the expected change in income over the two periods.
Because most of the countries under consideration have tax bases that are large!) unresponsive to changes in income, and because Libor income is highly correlated with ONP. the proxy used is likely to be fairly good.
Although not required, the estimation process was iterative in that at each stage the error covariance matrix was re-estimated to achieve convergence of the weighted sum of squared residuals.
The Hall specification (equation (21)) also yielded satisfactory results for the countries in the sample.