The Ricardian Equivalence under Collateral Constraints

Abstract

This paper investigates the Ricardian Equivalence (RE) under collateralized debt, default, transaction costs and incomplete markets. The public debt is neutral and the RE holds only if the collateral-transfer cost depends linearly on the lump-sum tax and is fully offset. Lenders and borrowers should enter in a voluntary agreement to compensate for any transfer cost under default. However, any perturbation in the assumed affine relation undermines the debt neutrality. It is not the transaction cost per se that invalidates the RE, but rather how this cost affects the households’ indebtedness and budget constraint. The underlying mechanism is the credit channel of the fiscal policy. Whenever the transfer cost is not fully offset, there is a net tax balance leftover that affects the budget set and real allocations. This is fundamentally different from a liquidity constrained economy because the credit channel of the fiscal policy is binding and uncompensated transaction costs lead to the RE failure.