Ricardian Equivalence Discourse (Advanced Macroeconomics)

 ● Ricardian Equivalence Parley

As we are all familiar with the Ricardian equivalence which pivotally focuses on the tax cuts in the short run so as to levy the higher tax rates in the future (will be discussed about Ricardian Equivalence in the upcoming blogs). 

Now, today what hit my mind is that, recardian equivalence actually is the result of the irrelevance of the government's financing decisions.

Let's take an example, say government is granting is "V" amount amount of bonds to the "H" households at "t1" time and the government is planning to retire the bond at the later time "t2".

So this implies the each of the households be taxed, [{e ^ R(t2) - R(t1)} × V] at time t2.

So this policy has 2 effects basically on the representative households. First, the household has acquired an asset i.e. bond that has Present Value as of t1 of V.

Second, it has acquired liability - the future tax obligation and that has the Present Value as of t1 as V.

Hence, the bond doea not represent net wealth to the households and it thus does not affect the consumption pattern of the Households behavior.

The household simply saves the bond and interest that the bond is accumulating until time t2 at which point it uses the bond interest to pay taxes thus the government is levying to retire the bond. 

The result follows solely from the households and government budget constraints, and not from any other features of the model.

Now, the traditional economic models assumes the shift from the tax to the bond finance increases consumption. The traditional analyses of consumption, for instance, mostly model consumption that depend only on current disposable income i.e. Y - T.

The views on consumption by Ricardian and Traditional domain have quite different implication when it comes to several policy issues.

The traditional views implies that the budget deficit are increasing consumption and thus reduce capital accumulation and growth. However, the Ricardian concept implies that they are having no effect on consumption and capital accumulation. 

For instance, government often cuts taxes in recession to increase consumption spending, nonetheless,  in the case of Ricardian Equivalence  all these process goes in vain.

Overall, it's important to determine which concept is near to the reality.

Thank You

Aditya Pokhrel

MBA, MA Economics, MPA