Ricardo Barro Effect – Definition

Cite this article as:"Ricardo Barro Effect – Definition," in The Business Professor, updated December 11, 2018, last accessed October 26, 2020, https://thebusinessprofessor.com/lesson/ricardo-barro-effect-explained/.

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Ricardo-Barro Effect Definition

The Ricardo-Barro Effect 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.
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.

A Little More on What is 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.

According to the 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. They will rather increase their savings in order to afford to pay the higher taxes in the future. It argues a government cannot stimulate a demand by increasing debt-financed government spending.

Ricardo-Barro effect, also known as Ricardian equivalence, has been criticized by the economists as it failed 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 of borrowing and saving money depends on a lot of factors and they do not have an absolute freedom to choose. The theory also assumes that individuals will save money for future tax increases which they may not even experience in their lifetime. In today’s economic scenario it doesn’t hold true. In the U.S, government borrowing is climbing high and yet the savings rate has hit a multi-decade low. The theory fails to explain this scenario.

However, the 2007 data of European Union countries showed a strong correlation between government debt finance and the individual’s financial assets. It was noticed in 12 of the 15 nations and it supports the argument of the theory of Ricardo-Barro effect.

References for Ricardo-Barro Effect

https://www.investopedia.com/terms/r/ricardobarroeffect.asp
https://www.businessdictionary.com/definition/Ricardo-Barro-Effect.html

https://www.forexpedia.org/glossary/view/ricardobarro_effect

Academic Research on Ricardo-Barro Effect

  • Barro on the Ricardian equivalence theorem, Buchanan, J. M. (1976). Journal of political economy, 84(2), 337-342. According to this study, this paper basically explains the Ricardo-Barro Effect. This theorem (Ricardian equivalence Theorem) was explained based on a lot of examples and a series of tests were carried out to justify this theorem and proves its usefulness to the economy at large.
  • The short-run macroeconomic effects of discretionary fiscal policy changes, Siwinska, J., & Bujak, P. (2006). The Eastern Enlargement of the Eurozone (pp. 131-145). Springer, Boston, MA. Judging from the Keynesian view as regards fiscal policy, it should be noted that fiscal policies are imposed by the government in form of tax on good produced in the economy which in turns affects the factors of production and the level of output. This paper, however, provides evidence based on the level of research that was carried out and claims that the consumption curve reacts in a non-linear fashion changes the fiscal policy. The result got from this research, however, shows that the household tends to behave in a non-Keynesian manner when the fiscal policy of an economy is floppy.
  • Exchange Rate Management: Intertemporal Tradoffs, Helpman, E., & Razin, A. (1985). According to the research drawn from this analysis, the exchange rate management can only be successful if and only if the government works towards improving the monetary-fiscal policy in consonance with its exchange rate targets. According to this study, a styled example of disinflation by the means of a suitable exchange rate was considered as well as a delayed accompanied absorption policy. The result gotten from this research gives a redistribution of welfare which indicates that the rate at which resources are spent falls than the later period while the external (home) debits rises at all times.
  • Fiscal deficits and relative prices in a growing world economy, Obstfeld, M. (1989). Journal of Monetary Economics, 23(3), 461-484 From, the result drawn from this research, the fiscal deficit was studies and its involvement and how it influences the economy as regards the monetary and fiscal policy in accordance with the relative prices in a growing economy was defined. The result, however, helps to explain the fiscal deficits and the relative prices in a growing world economy.
  • The logic of the Ricardian equivalence theorem, Brennan, G., & Buchanan, J. M. (1980). FinanzArchiv/Public Finance Analysis, (H. 1), 4-16. The result drawn from this research explains the logic of the Ricardian equivalence theorem. According to this thesis, the importance and effect of the Ricardian equivalence Theorem were studied and the behaviour of this theorem to the fiscal and monetary policy of an economy was as well studied.
  • International differences in saving, Bosworth, B. P. (1990). The American Economic Review, 80(2), 377-381. The life cycle and the demographic variables about the two-thirds of the observed variation in the savings rates of the OECD nations during the 1970s were researched and studied in this research thesis. This analysis, however, shows that the participation of the labour force of the working age population is a pertinent determinant in explaining the aggregate saving rate. It also discusses the variation in the household than it is in the national savings rate.
  • The incidence of a tax on pure rent: the old reason for the old answer, Fane, G. (1984). Journal of Political Economy, 92(2), 329-333. This research thesis base its explanation by introducing a hybrid approach to the joint estimation of Value at Risk (VaR) and the Expected Shortfall (ES) for high quantiles of the return distribution. This research studies the relative performance of the VaR and the ES models by using the report of a daily return gathered from 16 stock markets indices erstwhile to and during the financial crisis in 2008. The Back-testing result gotten from this result indicates that only the new hybrid and the Extreme Value Based VaR models gives maximum protection in both the emerging and developed market. But the hybrid method does this process in a significantly lower cost in capital reserve.
  • The Burden of the Public Debt: A Review, Cooper, J. H. (1988). South African Journal of Economics, 56(4), 173-181. This paper gives a full review of the burden placed on the economy by public debt. According to this research, the definition and various important explanations as regards the public debts and the implication on the economy at large were studied and exclusively determined.
  • Ricardo-Barro Equivalence Theorem and the Positive Fiscal Policy in China, LIU, X. H., & LV, S. Y. (2016). DEStech Transactions on Economics, Business and Management, (item). As a case study, this research paper majorly studied the positive fiscal policy in China. This research was analyzed with the background knowledge on the Ricardo-Barro Equivalence Theorem. This theorem helps to explain the influence of the positive fiscal policy; taking China as a case study.
  • Rational Expectations: An Econometric Investigation, junior Sophister, P. S. (1996). The analyses drew from this paper studies the system subject to change in regimes as a result of a discrete and occasional shift in the measurement governing the time series behaviour of exogenous economic variables. The main aim of this paper is in its interest in both the systemic and methodological contribution of new tools used for analyzing rational-expectation models. According to this paper, with the changes observed in the bivariate relation between the short and long rates under the expectations hypothesis of the term structure, an alternative nonlinear model that studies the possibility of changes in regime provided a much better description of the univariate process for short rates which helps to explain the whole process of the rational expectation.
  • Government Expenditures and Economic Growth: An Analysis of Developed, Developing and Underdeveloped Countries, Ağırman, E., & Yılmaz, Ă–. This research thesis explains the problem facing the government as regards how spending has a positive and significant impact on the growth of the economy and also the random effect model used by underdeveloped countries. This research also studies the way government spending affects the growth of the economy in the developed, underdeveloped and developing countries by making use of an unbalanced panel method throughout 1980-2012. This research claims that for the random effect model, there is a positive relationship between government expenditure and economic growth.
  • Some neglected economic factors behind the recent tax and spending limitation movements, Boskin, M. J. (1979). National Tax Journal, 32(2), 37-42. This paper explains the various neglected factors to consider when explaining the spending limitation movement and recent tax activities. These two factors are important in explaining the rate at which government spending affect the economic growth of any economy be it developed, developing or an underdeveloped economy.

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