R Minus g

Abstract

In long-term data, the dynamic efficiency condition, r>g, holds when g is the growth rate of GDP if r is the return on equity, re, but not if r is the risk-free rate, rf. This pattern accords with a disaster-risk model that fits observed equity premia. The equilibrium may feature rf≤g, which does not signal dynamic inefficiency. In contrast, re>g is required for dynamic efficiency, implied by the model, and consistent with data. With complete markets, the representative consumer's transversality condition translates into a no-Ponzi constraint on the public debt that the government can issue asymptotically. Therefore, fiscal changes do not affect the net wealth of the representative consumer, and Ricardian Equivalence holds. This result also holds in an example with incomplete markets where individual ownership of capital stocks cannot be fully diversified.