Ricardian equivalence is a result regarding the ineffectiveness of government due to consumption smoothing behavior of consumers. A primary reason why it fails is due to population turnover (i.e people have finite lives).

In spite of these issues why is Ricardian equivalence important to know about in terms of its use as actionable information.

  • $\begingroup$ Your question presumes it is. $\endgroup$ – Michael Greinecker Jan 6 at 18:20
  • $\begingroup$ @MichaelGreinecker if its not important why teach it? Presumably theres a reason why its taught. $\endgroup$ – EconJohn Jan 6 at 18:50
  • $\begingroup$ Something can be important without directly being related to "informing actionable policy." $\endgroup$ – Michael Greinecker Jan 6 at 18:52
  • $\begingroup$ @MichaelGreinecker I think that is a matter of educational philosophy. I have made a slight edit to the above question. $\endgroup$ – EconJohn Jan 6 at 19:46

This link to a 43 page paper: Ricardian equivalence: an empirical application to the Portuguese economy CarlosFonseca Marinheiro


Introduction on page 3:

The fiscal policy may be used with a stabilising role if the government finance decisions are able to influence private consumption (i.e., aggregate demand) and saving. This influence depends on the degree to which consumers treat government debt as net wealth.

If Ricardian equivalence holds then the government cannot stimulate aggregate demand by increasing spending and/or reducing taxes. So history of economic debate over the effectiveness of fiscal policy includes this theory called Ricardian equivalence.

According to the Keynesian consensus consumers treat government debt as net wealth. Therefore, a substitution of debt for taxes has a positive influence on private consumption and aggregate demand. However, the consequent decrease in private and national saving, implies an increase in the real interest rate, which crowds out private investment. The reduction in the capital accumulation then leads to a reduction of the long-term growth prospects of the economy. This negative long-run effect offsets some of the positive short-term effects of the government deficit.

The Ricardian thesis has a complete opposite view. It states that, for a given expenditure path, substitution of debt for taxes has no effect on aggregate demand nor in interest rates.The government’s inter-temporal budget constraint implies that, for an unaltered level of government outlays, a tax cut now implies a tax increase in the future. As borrowing only postpone taxes for the future, consumers, who are simultaneously taxpayers, anticipating the increase in future taxes, do not consider the current tax cut and the consequent increase in disposable income as being permanent. Their inter-temporal budget restriction is left unaltered. Therefore, consumption is also unaffected. The increased disposable income is entirely saved.

Then there is another historic economic debate over the concept called "crowding out."

  • $\begingroup$ Does real life not disprove this assertion that consumers anticipate future changes? $\endgroup$ – user253751 Jan 7 at 2:30
  • $\begingroup$ Barro is given credit for developing the theory of Ricardian equivalence. As I recall from earlier reading he may have admitted at some point that it is easy to dismiss Ricardian equivalence by rejecting one or more of the assumptions under which it might hold true. He then argued that it is still useful to question the effectiveness of fiscal policy under this theory. Personally I think if there is involuntary unemployment and persistently unused productive capacity in the economy then government deficit spending can stimulate aggregate demand without crowding out private investment. $\endgroup$ – SystemTheory Jan 7 at 2:41
  • $\begingroup$ that can only happen if private investment is suboptimal to begin with. Maybe one of the assumptions is that private investment is optimal. $\endgroup$ – user253751 Jan 7 at 2:52
  • $\begingroup$ Productive capacity utilization and levels of unemployment are econometric measures or statistical estimates not assumptions in a theoretical model. $\endgroup$ – SystemTheory Jan 7 at 2:54
  • $\begingroup$ One can assume that productive capacity is always fully utilized. $\endgroup$ – user253751 Jan 7 at 3:05

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