Ricardian Equivalence - Explained
What is the Ricardian Equivalence?
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Table of ContentsWhat is the Ricardian Equivalence?How is Ricardian Equivalence Used? Arguments Against the Ricardian EquivalenceExample of the Ricardian EquivalenceAcademic Research on the Ricardian Equivalence
What is the Ricardian Equivalence?
The Ricardian Equivalence is an economic proposition that holds that when there is increased debt-financed spending by the government in order to stimulate the economy, demands remain unchanged. Hence, this theory suggests that government deficit or a change in government spending does not cause a change in the overall demand in an economy. David Ricardo, a 19th-century British political economist developed the Ricardian Equivalence theory, this theory was subsequently revised by Robert Barro, a Harvard professor. The Ricardian Equivalence theory is otherwise known as the Barro-Ricardo equivalence proposition.
How is Ricardian Equivalence Used?
The underlying idea behind the Ricardian Equivalence proposition is that regardless of how a government increase spending (either debt-financed or tax-financed spending), demand in the economy remains the same. Both David Ricardo and Robert Barro argued that individual taxpayers and households save heavily in anticipation of government deficit which leads to higher taxes. Since taxpayers are aware that government deficit will be repaid, they use the excess money on their savings to pay for anticipated tax increases, which are subsequently used to repay government debt. The Ricardian Equivalence proposition maintains that a government cannot stimulate consumer spending in sick that when the government increases debt-financed spending, demand by Individuals and households remain the same.
Arguments Against the Ricardian Equivalence
Critics of the Ricardian Equivalence proposition argue that the proposition is premised on unrealistic assumptions. Some of the unrealistic assumptions of the Ricardian Equivalence include the existence of a perfect capital market where individuals and households can save excess money as they wish and also borrow whenever they want to. Another argument against the proposition is that oftentimes, individuals do not save an excess amount in anticipation of tax increase or heftier tax responsibilities. According to the critics of this proposition, Ricardo's theory is against the Keynesian economics theories.
Example of the Ricardian Equivalence
The Ricardian Equivalence theory proposes that the effect of government spending on consumer spending and demands is always the sadness, whether the pattern of government spending changes or not. For instance, individuals in a given economy save an excessive amount of money in expectation of bigger tax payments in the future to help the government offset debts. Since individuals already put aside enough money to cushion tax increase, their demand or spending is not affected by government spending.
Academic Research on the Ricardian Equivalence