Ricardian Equivalence

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Dictionary of Economics

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Ricardian Equivalence

What is Ricardian equivalence?

Ricardian equivalence is a scenario in which consumers respond to changes in fiscal policy in ways that make fiscal policy less effective.

For example, the government may cut taxes in an effort to stimulate the economy. But consumers may decide to save the money from the tax cuts rather than spend it.

What happens to the economy if that tax cut money is not spent? The aggregate demand curve doesn’t shift out, the multiplier is zero, and there are no systemic macroeconomic effects.

Ricardian equivalence (named after the 19th century British economist David Ricardo), is considered imperfect by most economists.

Why? Well, if we look at our example, it assumes that people are choosing to save rather than spend because they are expecting current tax cuts to be replaced with higher tax burdens in the future. But it’s a somewhat unrealistic model to expect all consumers to consider future tax burdens when making today’s spending and saving decisions.

Ricardian equivalence probably does describe some consumers, but not all and probably not most.

Interested in learning more about fiscal policy and its effects? Check out our Macroeconomics section on fiscal policy.

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What is Ricardian equivalence?

 

Named after David Ricardo -- a 19th-century British economist -- Ricardian equivalence is a scenario in which consumers respond to changes in fiscal policy in ways that make fiscal policy less effective.

 

If the government cuts taxes to stimulate the economy, people might then choose to save the tax cut instead of spending it. Now, saving money from a tax cut actually makes a lot of sense if people expect that tax cuts today will be matched by tax increases tomorrow. However, if people save their tax cuts instead of spending them, then the aggregate demand curve never shifts out, the multiplier will be zero, and there will be no systematic macroeconomic effects.

 

Most economists think Ricardian equivalence is imperfect and that it's somewhat unrealistic to model everyone as fully rational in incorporating their future tax burdens when making saving and spending decisions. So, Ricardian equivalence probably describes some people -- maybe not most people. In any case, to the extent that Ricardian equivalence reflects how people plan, tax cuts will be less effective as fiscal stimulus than they otherwise would be.

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