THE NEOCLASSICAL VIEW OF BUDGET DEFICIT

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.