Assessing Deviations from Ricardian Equivalence in an Endogenous Growth Model

This paper proposes a method for assessing the quantitative significance of deviations from the Ricardian equivalence hypothesis. The model proposed for this purpose belongs to a class of endogenous growth theories with investment adjustment costs, in which savings and investment are co-determined through adjustments in the real interest rate. The equilibrium investment rate determines the long-run growth rate, because of constant returns to capital accumulation due to externalities of the “learning by doing” type. We set up and compare two versions of the model, one with a representative household, in which Ricardian equivalence holds, and one with overlapping generations, in which it does not. We calibrate the two versions of the model using common parameter values and assess the significance of deviations from Ricardian equivalence in the overlapping generations model. For plausible parameter values, the differences in growth rates are of the order of 0.2 to 0.3 of a percentage point per annum, which accumulated over twenty five years are between 5.1%-7.8% of aggregate output. Neither growth rates nor interest rates appear to be particularly sensitive to the aggregate debt to output ratio. A rise of the debt to output ratio from 60% to 200% of aggregate output results in a decrease in the growth rate of about 0.03 of a percentage point, which accumulated over twenty five years is less than 1% of aggregate output. The differences for real interest rates are even smaller. Overall the results suggest that Ricardian equivalence is a relatively good approximation to reality, and the relative simplicity of the representative household model does not lead to predictions that would be too far off quantitatively, even if the world is characterized by overlapping generations.

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Savings, Investment and the Real Interest Rate in an Endogenous Growth Model

This paper compares the predictions of representative household models with those of models of overlapping generations, in the context of a class of endogenous growth theories with investment adjustment costs. In the model used in this paper, savings and investment are co-determined through adjustments in the real interest rate, and the equilibrium investment rate determines the long-run growth rate. The two classes of models have similar predictions regarding the effects of technological and preference shocks, but the overlapping generations model results in lower savings and investment, higher interest rates and lower growth rates that the corresponding representative household model. We calibrate the two models using similar parameter values and the results suggest that the differences between the two models are not quantitatively large. For plausible parameter values, the differences in growth rates, savings rates and investment rates are of the order of 0.1 to 0.2 of a percentage point per annum, which accumulated over twenty five years is at most 5% of aggregate output. The differences for real interest rates are even smaller. Overall the results suggest that the relative simplicity of the representative household model does not lead to results that would be too far off quantitatively, even if the world is characterized by overlapping generations.

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Working Paper 17-2012 Department of Economics AUEB