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The Effect of Government Deficits on Consumption and Interest Rates: A Two Equation Approach

Single-equation estimation of the consumption function often is used in testing the Ricardian equivalence theorem. This approach may be misleading, as effects on interest rates usually are ignored. This paper proposes simultaneous estimation of consumption and investment equations, with the interest rate serving to equilibrate the market. Five existing studies are replicated and subjected to sensitivity tests. The results show that the interest rate is important in the consumption function. The Ricardian equivalence theorem is tested, but the results are mixed.