On the Ricardian Equivalence Theorem in the Presence of Banks and a Reserve Requirement

We study the Ricardian Equivalence Theorem in the presence of a reserve requirement. Banks pay depositors the deposit rate and receive the borrowing rate on loans. Equivalence fails because the reserve requirement drives a wedge between the deposit and borrowing rates implying that government faces a different intertemporal tradeoff than savers. A tax cut financed by an increase in government debt causes an increase in savings but only increases the supply of loanable funds by a fraction because of the reserve requirement. This causes interest rates to rise and consumption to fall. We also show that if the central bank pays interest on reserves at the borrowing rate, the various rates are equal, however, equivalence still fails. The reason is that future taxes to pay down the debt must be higher for the central bank to pay interest and consumption will fall in response.