Ricardian Equivalence

Definition

Ricardian equivalence is an economic theory that suggests government borrowing does not affect private consumption and saving decisions. It proposes that when the government increases spending financed by debt, rational consumers will anticipate future tax increases to pay off the debt and will, therefore, save more to offset the future tax burden.

5 Must Know Facts For Your Next Test

1. Ricardian equivalence suggests that government borrowing does not affect private consumption and saving decisions.
2. According to Ricardian equivalence, when the government increases spending financed by debt, rational consumers will anticipate future tax increases to pay off the debt.
3. Ricardian equivalence proposes that consumers will save more to offset the future tax burden, leaving aggregate demand unchanged.
4. Ricardian equivalence assumes that consumers have perfect foresight and are fully rational in their decision-making.
5. Ricardian equivalence has important implications for the effectiveness of fiscal policy, as it suggests that government borrowing may not stimulate the economy as expected.

Review Questions

• Explain how Ricardian equivalence relates to shifts in aggregate demand.
  • According to Ricardian equivalence, when the government increases spending financed by debt, rational consumers will anticipate future tax increases to pay off the debt. In response, consumers will save more to offset the future tax burden, leaving aggregate demand unchanged. This suggests that government borrowing may not stimulate the economy as expected, as the increase in private saving offsets the increase in government spending, resulting in no net change in aggregate demand.
• Describe how Ricardian equivalence affects the relationship between government borrowing and private saving.
  • Ricardian equivalence proposes that when the government increases spending financed by debt, rational consumers will anticipate future tax increases to pay off the debt. As a result, consumers will save more to offset the future tax burden. This means that an increase in government borrowing will be matched by an equal increase in private saving, leaving the overall level of national saving unchanged. This suggests that government borrowing may not crowd out private investment, as the increase in private saving offsets the increase in government borrowing.
• Evaluate the assumptions and implications of Ricardian equivalence in the context of fiscal policy effectiveness.
  • Ricardian equivalence rests on the assumption that consumers have perfect foresight and are fully rational in their decision-making. If these assumptions hold true, then government borrowing may not have the expected stimulative effect on the economy, as the increase in private saving offsets the increase in government spending. This would suggest that fiscal policy, such as deficit-financed government spending, may be less effective in boosting aggregate demand and economic growth. However, if consumers do not behave as predicted by Ricardian equivalence, then fiscal policy may be a more potent tool for policymakers to influence the economy.

Related terms

Government Debt: The total amount of money owed by a government to its creditors, including both domestic and foreign lenders.

Fiscal Policy: The use of government spending and taxation to influence the economy's performance, including aggregate demand, employment, and inflation.

Aggregate Demand: The total demand for all goods and services in an economy at a given time and price level.