The neoclassical model has three
central features. Each of them plays an important role in determining the
impact of budget deficits
- The consumption of each individual is determined as the solution to an inter-temporal optimization problem, where both borrowing and lending are permitted at the market rate of interest.
- Individuals have finite lifespan. Each consumer belongs to a specific cohort or generation and the lifespan of successive generations overlap.
- Market clearing is generally assumed in all periods.
Consumers
behave as though they solve an inter-temporal optimization problem with access
to perfect capital markets. The formulation of the above assertion is based on
the stochastic permanent income hypothesis. Despite numerous problems with
estimation and interpretation, the evidence on balance supports the view that a
sizable minority (roughly 20%) of individuals fails to behave in a way that is
consistent with unconstrained inter-temporal optimization.
The finite
life span defines the central difference between the Neoclassical and Ricardian
frameworks. Also, the full employment is the primary distinction between the
neoclassical and Keynesian paradigms.
According to the neoclassical views of budget
deficits, if consumers are rational, fraught-ed and have access to perfect
capital markets. Then permanent deficits significantly depress capital
accumulation and temporary deficits have either a negligible or perverse effect
on the most economic variables (including consumption savings and interest
rates). Also, if many consumers are either liquidity constrained or myopic, the
impact of permanent deficits remains qualitatively unchanged. However,
temporary deficits should depress savings and raise interest rates in the short
run. Thus, the Neoclassical paradigm does not tie down the effects of temporary
deficit, and evidence that bears on the effects of temporary deficits is not
useful to testing this problem.
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