{"id":35215,"date":"2015-06-22T11:58:08","date_gmt":"2015-06-22T11:58:08","guid":{"rendered":"http:\/\/vskills.in\/certification\/blog\/?p=35215"},"modified":"2024-04-03T13:18:26","modified_gmt":"2024-04-03T07:48:26","slug":"ricardian-equivalence-3","status":"publish","type":"post","link":"https:\/\/www.vskills.in\/certification\/blog\/ricardian-equivalence-3\/","title":{"rendered":"Ricardian Equivalence"},"content":{"rendered":"
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\"Ricardian<\/a><\/p>\n<\/blockquote>\n

David Ricardo<\/strong> was a British political economist. One of his famous works is the Ricardian equivalence. According to Ricardian equivalence, consumers are forward looking and their consumption depends not only on the current income but also on the expected future income. It states that changes in the budgetary decisions don\u2019t affect the consumption pattern of the people. It is used to analyse fiscal policies.<\/p>\n

Suppose the government proposes a tax cut today and there is no change in the government spending. When a budget is balanced, the taxes are equal to government spending (G = T). A tax cut implies more current income for the people and therefore, consumption should increase and savings should fall as a result of increased income. But David Ricardo claimed that because the consumers are forward looking they understand that a tax cut today implies a budget deficit (G > T i.e. spending is more than tax revenue)<\/strong>, and the deficit will be financed by higher taxes in future. A tax cut which is financed by government borrowing does not reduce the tax burden, it just reschedules it, and therefore, the rational consumers must not increase their consumption as increased current income will balance decreased expected future income. Hence he claimed that financing a government by debt is equivalent to financing it by taxes.<\/p>\n

According to the proposition, there is no change in the aggregate consumption patterns. Also, the extra disposable income is saved to offset the increase taxes in future. But then what is the use of fiscal policies if everything is unchanged?<\/p>\n

In order to stimulate consumption or savings, fiscal policies should be formed keeping in mind the assumption of forward looking rational consumers. If the government states that a tax cut today will be financed by a reduction in the government spending, then, people will increase their consumption as there is no future tax liability on them. This will then fulfill the objectives of fiscal policies.<\/p>\n

But at the same time, there are some arguments which question the ricardian equivalence proposition:<\/p>\n