What is the Ricardo-Barro Effect?

The Ricardo-Barro Effect, also known as Ricardian equivalence, is a microeconomic concept that suggests when there is a reduction in government spending and an increase in taxation; in response, households and businesses increase their level of savings to pay for the higher taxes that are expected in future.  

In summary, it says, when a government tries to stimulate the economy by increasing the tax rate and reducing its spending, the public will respond by increasing their savings. Thus, the demand remains unchanged.

What Introduced the Ricardo-Barro Effect? 

The concept of Ricardo-Barro Effect was first introduced by David Ricardo in the 19th century. The concept was further developed by Harvard professor Robert Barro who provided a more elaborate version of the theory. 

Further Explanation of the Ricardo-Barro Effect?

According to the Ricardian Equivalence theory, the lifetime present value of one’s after-tax income (intertemporal budget constraint) determines his or her consumption and spending. 

So, if the tax rate is increased by the government the spending of the public will reduce. The public will increase its savings in order to afford to pay the higher taxes in the future. 

Thus, the Ricardo-Barro Effect argues that a government cannot stimulate consumer demand by increasing debt-financed government spending. 

Critiques of the Ricardo-Barro Effect?

Ricardo-Barro effect has been criticized by the economists as it fails to explain certain spending and savings pattern of the public. Economists argue that the theory is based on some unrealistic assumptions. 

The theory of Ricardo-Barro effect assumes that a perfect capital market exists, and the individual has the ability to decide when to borrow and save money. 

In reality, an individual’s decision to borrow or save money depends on a lot of factors and they do not have an absolute freedom to choose. 

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• Total utility
• Marginal Utility
• Diminishing Marginal Utility
• Marginal Utility per Dollar
• Rule of Maximizing Utility
• Consumption
• Consumer Goods
• Changes in Income Affect Consumer Choices
• Changes in Price Affect Consumer Choices
• Substitution Effect
• Income Effect
• Budget Constraints Create Demand Curves
• Lifecycle Model of Consumption
• Autonomous Consumption
• Permanent Income Hypothesis
• Lipstick Effect
• Engel’s Law
• Consumerism
• Paradox of Thrift
• Ricardo Barro Effect
• Consumer Confidence Index
• The Wealth Effect
• Behavioral Economics

Other Related Topics

• What is Government Spending?
• Autonomous Spending
• Autonomous Consumption
• Fiscal Policy
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• Contractionary Fiscal Policy
• Progressive vs Regressive Tax
• Marginal Tax Rates
• Proportional Tax
• Trickle Down Theory
• Discretionary Fiscal Policy
• Automatic Stabilizers
• Effects of Discretionary Policy (Interest Rates & Lags)
• Crowding Out Effect 
• National Debt
• Government Borrowing
• Golden Rule
• Ricardian Equivalence
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• National Debt
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• Twin Deficits
• Fiscal Policy and the Aggregate Supply and Demand Curve
• Stabilization Policy
• Robin Hood Effect
• Ricardo Barro Effect
• Automatic Stabilizers
• Standardized Employment Budget
• How Does Fiscal Policy Affect Interest Rates? 
• Crowding Out
• Types of Lag in Fiscal Policy
• Temporary and Permanent Fiscal Policy
• Limitations of Fiscal Policy?
• How Politics Affects Discretionary Fiscal Policy
• Government Borrowing
• National Savings and Investment Identity
• Debtor Nation
• Fiscal Policy Affects Trade Balances
• Twin Deficits
• Exchange Rates Affect Budget and Trade Deficits
• What are the risks of chronic large deficits in the United States?
• How Fiscal Policy Can Affect Trade Imbalances
• Government Borrowing Affect Private Savings
• Ricardian Equivalence
• Fiscal Policy Affects Investment and Economic Growth
• Crowding Out of Physical Capital Investment?
• How Does Government Borrowing Affect Interest Rates in Financial Markets?
• Government Investment in Physical Capital
• Public Investment in Human Capital
• Fiscal Policy Can Affect Technology Development

• Economic Cycle or Business Cycle
• Business Cycle Indicator
• Peak and Trough
• Recession and Depression
• Hard Landing vs Soft Landing
• Economic Bubble
• Boom and Bust Cycle
• Great Depression
• Baby Boomer Age Wave Theory

• Skyscrapper Effect (Economics)
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• U-Shaped Recovery
• Kondratieff Wave Cycle
• Contagion
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• CNN Effect
• Bureau of Economic Analysis
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