Ricardian equivalence

(W)

The Ricardian equivalence proposition (also known as the Barro-Ricardo equivalence theorem) is an economic theory that suggests consumer internalize the government’s budget constraint and this the timing of any tax change does not affect their change in spending. Consequently, Ricardian equivalence suggests that it does not matter whether a government finances its spending with debt or tax increase, the effect on total level of demand in an economy being the same.

See David Ricardo, 1772-1823st book on economic theory Principles of Political Economy.

Introduction

In its simplest terms: governments can raise money either through taxes or by issuing bonds. Since bonds are loans, they must eventually be repaid – presumably by raising taxes in the future. The choice is therefore ‘tax now or tax later’.

“Essay on the Funding System” (1820) – people are subjected to a fiscal illusion.

Barro-Ricardo Equivalence

In 1974, Robert J. Barro provided some theoretical foundation for Ricardo’s hesitant speculation. Barro’s model assumed the following:

- Families act as infinitely lived dynasties because of intergenerational altruism

- Capital markets are perfect ( i.e., all can borrow and lend at a single rate) (c- liquidity constraints)

- The path of government expenditure is fixed

Under these conditions, if governments finance deficits by issuing bonds, the bequests that families grant to their children will be just large enough to offset the higher taxes that will be needed to pay off those bonds. Among his conclusion, Barro wrote:

… in the case where the marginal net-wealth effect of government bonds is close to zero … fiscal effect involving changes in the relative amounts of tax and debt finance for a given amount of public expenditure would have no effect on aggregate demand, interest rates, and capital formation

The model was an important contribution to the New Classical Macroecon. built around the assumption of rational expectations.

In the 1979, Barro defined the RE as follows:

… shifts between debt and tax finance for a given amount of public expenditure would have no first-order effect on the real interest rate, volume of private investment, etc. noting that “(t)he RE proposition is presented in Ricardo. However, Ricardo was skeptical of this equivalence.

TBC …

See Wikipedia