Ricardian Equivalence

What does it mean?

The Ricardian equivalence proposition is an economic hypothesis holding that consumers are
forward looking and so internalize the government's budget constraint when making their
consumption decisions. This leads to the result that, for a given pattern of government spending, the
method of financing such spending does not affect agents' consumption decisions, and thus, it does
not change aggregate demand.

Who proposed it?

This theory was developed by David Ricardo in the early 19th century and later was elaborated
upon by Harvard professor Robert Barro. Thus, it is also known as the Barro-Ricardo equivalence
proposition.

What are the implications of the equivalence?

The proposition implies that there would be no change in the aggregate demand from increased
consumer spending. There would only be change in the level of savings with the timings of th. This
translates to the fact that the Keynesian fiscal policy will generally be ineffective at boosting
economic output and growth.

What are the assumptions of Ricardian Equivalence?

1.) The number of citizens obliged to pay taxes is constant

2.) Capital markets are perfect (in terms of no liquidity constraints)
3.) Economic agents are infinite-living, forward-looking and rational
4.) Future income flows and future tax burdens are certain
5.) Taxes are non-distortionary and are collected as a lump-sum per capita.
Is there any real life evidence of the equivalence?

When budget deficits got very large in 2008 and 2009, there was some sign of a rise in saving. A
variety of statistical studies based on the U.S. experience suggests that when government borrowing
increases by $1, private saving rises by about 30 cents. A World Bank study done in the late 1990s,
looking at government budgets and private saving behavior in countries around the world, found a
similar result.

Is there any mathematical model to prove the proposition?

The equation, given by David Ricardo, establishes the proposition. For reference on derivation,
check out the annexure attached.

WE = y1 + y2/ (1+r) – 1/N [G1 + G2/ (1+r)]

Here; WE = Consumer’s overall wealth, N = Population, T = Total tax per Revenue, G = Government
Spending, t = Tax per person, yi = Income in period I (i=1/2)
Criticisms of the Equivalence

The proposition has been criticized by Paul Krugman, Lucas and many others economists. The
opposition for the theory primarily stems from the irrelevance of the same in real life world. For
instance, the equivalence doesn’t hold when the credit market is imperfect (like different borrowing
and lending rates, credit limits, limited commitment and the housing model, asymmetric information),
consumers and governments face different life spans, distortionary taxes (not lump-sum)
affect the decision to work etc.

Does RE hold in developing countries?

Prima facie, since the REP requires a number of assumptions that might not appear to be satisfied in
developing countries, it seems that the REP should not hold. However, the empirical evidence
provided so far is mixed. REP does hold for countries like Burundi, El Salvador, Ethiopia, Honduras,
Morocco, Nigeria, Pakistan, and Sri Lanka. Additionally, Ghatak (1996) provided evidence to support
REP does not hold in one developing country, India.