Ricardian equivalence. Suppose the market interest rate on 20-year bonds is 7%.

Question

Ricardian equivalence. Suppose the market interest rate on 20-year bonds is 7%. Also suppose that the federal government borrows $2 billion by selling 20-year zero-coupon bonds for $2 billion today. (The current market values of these bonds add up to $2 billion. Because these are zero-coupon bonds, the government only makes one payment on each bond – the payment when the bonds mature in 20 years.) a. (2 points) Which curve, supply or demand, shifts because the government sells a $2 billion bond? Which way does it shift, to the right or to the left? By how much does it shift?

Explanation / Answer

Ricardian equivalence is an economic theory that suggests that when a government tries to stimulate an economy by increasing debt-financed government spending, demand remains unchanged. This is due to the fact that the public saves its excess money to pay for expected future tax increases that will be used to pay off the debt. This theory was developed by David Ricardo in the 19th century but was revised by Harvard professor Robert Barro into a more elaborate version of the same concept.

A zero-coupon bond is a bond that makes no periodic interest payments and is sold at a deep discount from face value. The buyer of the bond receives a return by the gradual appreciation of the security, which is redeemed at face value on a specified maturity date.

The price of a zero-coupon bond can be calculated by using the following formula:

P = M / (1+r)n

where:
P = price
M = maturity value
r = investor's required annual yield / 2
n = number of years until maturity x 2

Zero-coupon bonds are usually long-term investments; they often mature in ten or more years. Although the lack of current income provided by zero-coupons bond discourages some investors, others find the securities ideal for meeting long-range financial goals like college tuition. The deep discount helps the investor grow a small amount of money into a sizeable sum over several years.

Because zero-coupon bonds essentially lock the investor into a guaranteed reinvestment rate, purchasing zero-coupon bonds can be most advantageous when interest rates are high. They are also more advantageous when placed in retirement accounts where they remain tax-sheltered. Some investors also avoid paying taxes on imputed interest by buying municipal zero-coupon bonds, which are usually tax-exempt if the investor lives in the state where the bond was issued.

The lack of coupon payments on zero-coupon bonds means their worth is based solely on their current price compared to their face value. Thus, prices tend to rise faster than the prices of traditional bonds when interest rates are falling, and vice versa. The locked-in reinvestment rate also makes them more attractive when interest rates fall.

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