Ricardian equivalence

economic-dictionary

Ricardian equivalence is an economic theory that suggests that when a government increases debt-financed expenditures to try to stimulate demand, demand does not actually undergo any change.

This is because increases in the public deficit will lead to higher taxes in the future. To keep their consumption pattern stable, taxpayers will reduce consumption and increase their savings in order to offset the cost of this future tax increase.

If taxpayers reduce their consumption and increase their savings by the same amount as the debt that the government must repay, there is no effect on aggregate demand.

The fundamental concept of Ricardian equivalence is that no matter what method the government chooses to increase spending, whether by issuing public debt or through taxes (applying an expansionary fiscal policy), the result will be the same and demand will remain unchanged.

This theory was developed in the 19th century by David Ricardo, hence its name. Years later, Harvard professor Robert Barro would implement Ricardo's ideas in more elaborate versions.

Criticisms of the Ricardian equivalence

The main criticisms of this theory are due to the unrealistic assumptions on which the theory is based. These assumptions include:

  • Existence of perfect capital market.
  • Individuals' ability to lend and save whenever they want.
  • Individuals are willing to save to prevent future tax increases. Even though these never affect them.

On the other hand, David Ricardo's theory is contrary to the more popular theories of Keynesian economics.

Tags:  history economic-analysis accounting 

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