Ricardian equivalence
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Ricardian equivalence, or the Barro-Ricardo equivalence proposition, 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.
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.
More recently, economists such as Robert Barro have developed more sophisticated variations on the same idea, particularly using the theory 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.
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.
- 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..
External links
- Does It Matter How You Pay for a State Dinner? A Lesson on Ricardian Equivalence by Morgan Rose, at the Library of Economics and Liberty
- Biography of David Ricardode:Ricardianische Äquivalenz