Ricardian Equivalence Proposition in a NK DSGE Model for two Large Economies: The EU and the US

Jorge Fornero

Working Papers Central Bank of Chile from Central Bank of Chile

Abstract: This paper examines the macroeconomic effects of active fiscal policy management coupled with a monetary policy that follows the Taylor principle. The objective is to investigate the relevance of the Ricardian Equivalence Proposition (REP) in a framework where two large open economies interact and a fraction of the consumers is financially constrained. According to an estimated vector autoregressive model, a positive shock in government expenditure leads to an increase in private consumption (at odds with the permanent income hypothesis). The channels are studied in a fully microfounded dynamic stochastic general equilibrium model economy calibrated for the Euro Area (EU-12) and for the United States. The crucial parameter that drives the break of the REP is the share of financially constrained consumers. Firms produce tradable varieties in a monopolistic competition framework and pricing is à la Calvo, which leads to nominal price stickiness. Labor varieties are immobile across countries and are demanded in an aggregated fashion by firms. Fiscal policy is specified as a time-consistent rule. We simulate through impulseresponse functions parameterizations that yield results consistent with the REP, and estimate a subset of deep parameters employing Bayesian techniques.

Date: 2010-03
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