Ricardian equivalence

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Ricardian equivalence, (also known as Barro-Ricardo equivalence proposition or Ricardian rent), is an economic theory which suggests that government budget deficits do not affect the total level of demand in an economy. It was proposed, and then rejected, by the 19th century economist David Ricardo.

1 Introduction
2 Assumptions of Ricardian equivalence
3 See also
4 External links

[edit] Introduction

In simple terms, the theory can be described as follows. Governments may either finance their spending by taxing current taxpayers, or they may borrow money. However, they must eventually repay this borrowing by raising taxes above what they would otherwise have been in future. The choice is therefore between "tax now" and "tax later".

Suppose that the government finances some extra spending through deficits - i.e. tax later. Ricardo argued that although taxpayers would have more money now, they would realise that they would have to pay higher tax in future and therefore save the extra money in order to pay the future tax. The extra saving by consumers would exactly offset the extra spending by government, so overall demand would remain unchanged.

In 1974 Robert J. Barro published an article entitled "Are Government Bonds Net Wealth?" in the Journal of Political Economy (Vol. 82, No. 6. (Nov. - Dec., 1974), pp. 1095-1117). This model assumes that families act as infinitely lived dynasties because of intergenerational altruism, capital markets are perfect (meaning that all can borrow and lend at a single rate) and the path of government expenditures are fixed. Under these conditions, if governments finance deficits by issuing bonds, families will grant bequests to children just large enough to offset the higher taxes that will be needed to pay the taxes needed to pay off those bonds. This paper was an important contribution to the New Classical Macroeconomics, built around the assumption of rational expectations.

Ricardian Equivalence suggests that government attempts to influence demand using fiscal policy will prove fruitless. It can be contrasted with alternative theories in Keynesian economics. In Keynesian models, a multiplier effect means that fiscal policy, far from being impotent, has a geared effect on demand, with a one pound increase in deficit spending increasing demand by more than one pound.

Empirical research rejects Ricardian equivalence in its pure form, although some studies have found Ricardian effects in saving behavior. For a technical review of the literature, see M. Gabriella Briotti, “Economic Reactions to Public Finance Consolidation: a Survey of the Literature,” European Central Bank Occasional Paper No. 38, Oct. 2005.

[edit] Assumptions of Ricardian equivalence

Ricardian equivalence states that a deficit-financed increase in government spending will not lead to an increase in aggregate demand. If consumers are 'Ricardian' they will save more now to compensate for the higher taxes they expect to face in the future, as the government has to pay back its debts. The increased government spending is exactly offset by decreased consumption on the part of the public, so aggregate demand does not change.

To work, this needs several conditions, most commonly:

A perfect capital market where any household can borrow or save as much as is required at a fixed rate which is the same for all persons at a given date.
The path of government spending is fixed
Intergenerational concern. The tax rise required may not occur for centuries, and will be paid off by the great-great-grandchildren of the population around at the time the debt was incurred. Ricardian equivalence only happens when the current generation has some concern for all future generations, even if not perfect concern. Barro phrased this as "any operative intergenerational transfer".

These assumptions are widely challenged. The perfect capital market hypothesis is often held up for particular criticism because of the existence of liquidity constraints which invalidate the lifetime income hypothesis which it is based on. The existence of international capital markets also complicates the picture.

However, the underlying intuition of the Barro-Ricardo model is that individual action can unravel Government policy, that the economy does not act in a mechanistic manner, and that policies can have unintended consequences. This is a key point of modern macroeconomic policy.