Ricardian equivalence

Ricardian Equivalence is an economic theory that suggests that when a government increases expenses financed with debt to try to stimulate demand , demand does not really 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 to be returned by the government, there is no effect on aggregate demand .

The fundamental concept of Ricardian equivalence is that it does not matter which method the government chooses to increase spending, whether by issuing  public debt  or through taxes (applying an expansive fiscal policy ), the result will be the same and demand will remain unchanged.

This theory was developed in the nineteenth century by David Ricardo, hence his name. Years later, Harvard professor Robert Barro would implement Ricardo’s ideas in more elaborate versions.

Criticisms of Ricardian equivalence

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

  • Existence of perfect capital market.
  • Ability of individuals to lend and save whenever they want.
  • Individuals are willing to save to prevent future tax increases. Even if they never affect them.

 

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