Ricardian Equivalence

The Ricardian equivalence is a proposition named after the economist David Ricardo. The key idea behind Ricardian equivalence is that the choice of financing the current deficit by the government (increase in tax, or spending with debt) is irrelevant. This is because effect of this choice on aggregate demand is the same.

Let's explore this idea in detail. When the government has a deficit, it has two choices to raise money: increase tax, or issue bonds. The second option of using debt is also related to the first option, because the bonds represent debt that needs to be repaid in the future. To repay the debt, the government is likely to raise taxes. So, the real choice is whether to increase taxes now or in the future.

Assume that the government issues debt to finance its extra spending, that is, it has chosen to increase taxes later. The tax payers will now expect that they will have to pay higher taxes in the future. To offset this additional future cost, they will reduce their consumption and increase saving. Therefore, the effect on the aggregate demand will be the same, as if the government had chosen to increase taxes now.

Ricardian equivalence depends on how well the taxpayers are able to predict their future increase in liability.

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