The Neoclassical Growth Model - and Ricardian Equivalence

This textbook provides a detailed summary of the key elements within The Neoclassical Growth Model and the Ricardian Equivalence.

1. Introduction

2. The neoclassical growth model

3. The steady state

4. Ricardian equivalence

5. Conclusions

Appendix A
A1. The maximization problem of the representative firm
A2. The equilibrium value of the representative firm
A3. The goverment’s intertemporal budget constraint
A4. The representative household’s intertemporal budget constraint
A5. The maximization problem of the representative household
A6. The consumption level of the representative household

Appendix B

References

This note presents the neoclassical growth model in discrete time. The model is based on microfoundations, which means that the objectives of the economic agents are formulated explicitly, and that their behavior is derived by assuming that they always try to achieve their objectives as well as they can: employment and investment decisions by the firms are derived by assuming that firms maximize profits; consumption and saving decisions by the households are derived by assuming that households maximize their utility.1

The model was first developed by Frank Ramsey (Ramsey, 1928). However, while Ramsey’s model is in continuous time, the model in this article is presented in discrete time.2 Furthermore, we do not consider population growth, to keep the presentation as simple as possible.

The set-up of the model is given in section 2. Section 3 derives the model’s steady state. The model is then used in section 4 to illustrate Ricardian equivalence. Ricardian equivalence is the phenomenon that - given certain assumptions - it turns out to be irrelevant whether the government finances its expenditures by issuing public debt or by raising taxes. Section 5 concludes.