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Ricardian equivalence

From Academic Kids

Ricardian equivalence, or the Barro-Ricardo equivalence proposition, is a controversial economic theory which suggests that government budget deficits do not affect the total level of demand in an economy. It was proposed 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.

To demonstrate perfect Ricardian Equivalence in an economic model requires a number of restrictive assumptions, and it is controversial whether the idea has any relevance for actual modern economies.

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