Ricardian Equivalence

DEFINITION of 'Ricardian Equivalence'

An economic theory that suggests that when a government tries to stimulate demand by increasing debt-financed government spending, demand remains unchanged. This is because the public will save its excess money in order to pay for future tax increases that will be initiated to pay off the debt. This theory was developed by David Ricardo in the nineteenth century, but Harvard professor Robert Barro would implement Ricardo's ideas into more elaborate versions of the same concept.

Also known as "Barro-Ricardo equivalence proposition"

BREAKING DOWN 'Ricardian Equivalence'

The basic idea behind Ricardo's theory is that no matter how a government chooses to increase spending, whether with debt financing or tax financing, the outcome will be the same and demand will remain unchanged. The major arguments against Ricardo's theory are due to the unrealistic assumptions on which the theory is based, such as the assumptions of the existence of perfect capital markets, the ability for individuals to borrow and save whenever they want, and the assumption that individuals will be willing to save for a future tax increase even though they may not see it in their lifetimes. Furthermore, the theory provided by Ricardo goes against the more popular theories provided by Keynesian economics.

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