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The author is grateful to Willem Buiter, Mansoor Dailami, Mohsin Khan, Ricardo Martin, Peter Montiel, Assaf Razin and Sweder van Wijnbergen for helpful comments and discussions.
See Buiter (1977) and Bailey (1962, 1971).
For an excellent recent survey of the growing literature in this area see Leiderman and Blejer (1986) (see also Seater (1985)).
Blanchard (1983) developed the theoretical framework following an approach used by Yaari (1965). Frenkel and Razin (1986) and Buiter (1986) have provided extensive analyses to study fiscal policy using this approach.
See Leiderman and Blejer (1986) for a detailed discussion of the implications of relaxing these assumptions.
The only exception being Leiderman and Razin (1986) who test for Ricardian equivalence in Israel using an approach similar to this paper.
Since Blanchard (1985) used Yaari’s (1985) model of finite lived consumers to study fiscal policy, the modelling approach used here is interchangeably attributed to Blanchard and to Blanchard and Yaari.
See Buiter (1986).
For simplicity this section does not consider the case of uncertainty but develops only the case of static expectations in the case of perfect certainty.
Hall (1978) argued that consumption was essentially a random walk, in that current consumption was expected to be the same as last period’s consumption but for a random element. However, Flavin (1981) correctly pointed out that consumption would be an exact random walk only if the transitory component of income were identically equal to zero. In our specification the counterpart of the Flavin transitory component is the expected change in income over the two periods.
Note that as before if the probability of survival is equal to one, then the specification (28) reduces to the Hall hypothesis that consumption is a random walk.
Since most of the countries under consideration have tax bases that are largely unresponsive to changes in income and since labor income is highly correlated with gross national product, 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 our sample.