Outline and explain The Ricardian Equivalence Theorem and assess the evidence bearing on it.
The Ricardian Equivalence Theorem, developed by David Ricardo and advanced by Robert Barrow in the 19th century, suggests that taking into account the government budget constraint a budget deficit will have no effect on national saving- the sum of private and public saving, in an economy. In this essay I am going to explain the reasoning behind this, assess its likelihood and finally review evidence either supporting or opposing the theorem.
In an economy, if government spending exceeds government revenues, borrowing money (for example by issuing government bonds or increasing taxation) can finance the deficit.
Ricardian Equivalence states that if a government opts to tax ‘in the future’ and instead borrow money, even though economic agents now have more disposable income, they do not alter their real spending patterns, as they fully predict future tax increases in order to finance governments outstanding bonds and so results in having no effect on an agent's intertemporal budget constraint. As such agents choose to save now so that they have enough when taxes are increased in the future to pay back the borrowing. Due to households holding both assets (government bonds) and liabilities (future tax obligation), this does not represent net wealth for them . Consumers are saving exactly the same amount governments are overspending, and so total demand is unaffected.
As a result, Ricardian Equivalence Theorem implies that using active fiscal policy to alter aggregate demand proves ineffective. This is in stark contrast with the Keynesian economic theory (fig 1), whereby increasing government spending increases both output and the interest rate, as they ...