What is the 'Ricardian Equivalence'

Ricardian equivalence is an economic theory that suggests that when a government tries to stimulate an economy by increasing debt-financed government spending, demand remains unchanged. This is due to the fact that the public saves its excess money to pay for expected future tax increases that will be used to pay off the debt. This theory was developed by David Ricardo in the 19th century but was revised by Harvard professor Robert Barro into a more elaborate version of the same concept.

BREAKING DOWN 'Ricardian Equivalence'

Ricardian equivalence, also known as the Barro-Ricardo equivalence proposition, stipulates that a person's consumption is determined by the lifetime present value of his after-tax income. Therefore, the Ricardian equivalence says a government cannot stimulate consumer spending since people assume that whatever is gained now will be offset by higher taxes due in the future. Thus, the underlying 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 is the same and demand remains unchanged.

Arguments Against the Ricardian Equivalence

The major arguments against Ricardo's theory are due to what are perceived as the unrealistic assumptions on which the theory is based. These assumptions include such things as the existence of perfect capital markets and the ability for individuals to borrow and save whenever they want – scenarios which are not realistic. Additionally, there is the assumption that individuals are willing to save for a future tax increase, even though they may not see it in their lifetime. The theory espoused by Ricardo goes against the more popular theories provided by Keynesian economics.

Real-World Proof of the Ricardian Equivalence

It has been established that the Ricardian equivalence suggests a government has the same effect on consumer spending regardless of its debt levels or tax burdens. As a government increases spending to stimulate the economy, it takes out more debt, and people put aside money in expectation of higher future taxes to offset the debt. Therefore, logic follows that if the Ricardian equivalence is true, then countries with high levels of debt should also have comparatively higher levels of household savings.

As an example, when looking at government debt to GDP in relation to household net financial assets to GDP for countries within the European Union (EU) during the 2008 financial crisis, there is evidence to support the validity of the Ricardian equivalence. Based on data from 2007, there is a strong correlation between government debt burdens and net financial assets accumulated for 12 of the 15 countries within the union.

RELATED TERMS
  1. Ricardo-Barro Effect

    According to the Ricardo-Barro effect, also known as Ricardian ...
  2. Deficit

    A deficit is the amount by which a resource falls short. It is ...
  3. Government Purchases

    Government purchases are expenditures and gross investment by ...
  4. Time-Preference Theory Of Interest

    The time preference theory of interest explains interest rates ...
  5. New Growth Theory

    New growth theory is a concept that presumes the desire and wants ...
  6. Net Debt

    Net debt is a metric that shows a company's overall debt situation ...
Related Articles
  1. Insights

    Successful Ways That Governments Reduce Federal Debt

    Governments have many options when trying to reduce debt, and throughout history some of them have actually worked.
  2. Insights

    The National Debt Explained

    We know it's growing, but we don't know exactly how. An in-depth look why the U.S. Government's debt continues to balloon and what it all means for you.
  3. Investing

    Seven Controversial Investing Theories

    Find out information about seven controversial investing theories that attempt to explain and influence the market as well as the actions of investors.
  4. Financial Advisor

    High Debt and Savings Rates Hinder China's Economy

    China's recent debt explosion seems odd considering its high savings rate, but the two are related and may provide the key for renewed growth.
  5. Insights

    What the National Debt Means to You

    The U.S. deficit seems to grow every year. But how does it actually affect you?
  6. Insights

    Inspecting A Country's Debt

    Tensions over just how to handle debt are pitting the rich world against the developing world like never before.
  7. Investing

    Deflation and Debt: Is the United States the New Japan?

    Discover how mainstream macroeconomics has failed Japan and why the United States should take care to avoid Japan's borrow, spend and print model.
  8. Insights

    The U.S. National Spending And Debt

    Just like any average American household, government overspending can carry on for extended periods by rolling over debt and borrowing more and more money in what seems like a never-ending game ...
  9. Investing

    How Is the Bank of Japan Monetizing Government Debt?

    With its massive QE program and more recent adoption of negative interest rates, it looks like the BOJ is monetizing the Japanese government's debt.
RELATED FAQS
  1. What Is the Ricardian Vice?

    The Ricardian vice refers to model building and mathematical formulas with unrealistic assumptions. Read Answer >>
  2. What are the pros and cons of operating on a balanced-budget?

    Take a brief look at some of the major arguments for and against balanced budgets for the U.S. government, the largest debtor ... Read Answer >>
  3. How does the crowding out effect influence the multiplier effect of a government ...

    Understand the theories of the multiplier effect and the crowding-out effect, and learn how these two theories represent ... Read Answer >>
  4. What is the role of deficit spending in fiscal policy?

    Read about the role deficit spending can play in a government's fiscal policy, and learn why economists are torn about the ... Read Answer >>
  5. What is the Keynesian multiplier?

    Introduced by Richard Kahn in the 1930s, the Keynesian multiplier demonstrated that any government spending brings about ... Read Answer >>
Hot Definitions
  1. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  2. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  3. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  4. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
  5. Dividend

    A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
  6. Inventory Turnover

    Inventory turnover is a ratio showing how many times a company has sold and replaces inventory over a period.
Trading Center