Question

Write a simple macroeconomic model where Ricardian equivalence does not hold. Explain why Ricardian equivalence does not hold in this model by deriving necessary conditions.

Answer 1

Meaning of Ricardian Equivalence: -

The Ricardian Equivalence is a hypothetical theory in which, the author says that economic growth cannot happen as the government tries to increase demand using debt financing. He says that government debt leads to higher tax rates in the future which are already calculated by the consumers who will save the additional money which the government borrowing creates and not purchase or increase their demand and thus the economy cannot grow.

This theory has readily been rejected by numerous economists for the lack of a larger view point and the fact that any release of currency in the economy leads to creation of new jobs, and the existing ones gain in value. Economic growth is also not considered to be an important factor and is explained as follows: -

Model Where Ricardian Equivalence does not hold: -

Economists over a period of time realized that Ricardian equivalence was only hypothetical in existence and that pumping money into the economy through debt financing also has a net positive effect. To add 2 Million dollars into the economy a loan of that amount is not needed.

In any economic model, not all consumers are rational and expect future tax additions to their income. As long as they have additional money in their pockets due to government intervention, they will not reduce their demand. Further in this economic model, the rate of economic growth is much higher than the interest rates which the government needs to pay on the debt itself. For example, if the growth rate is 10% in a fiscal year, and the rate of interest is only 5%, growth of 5% is said to have happened and will not hamper future tax rates if any. People are ready to pay increased taxes as long as their total income increases.

Thus, in an economic model, which defies the Ricardian Equivalence, the growth rate is much higher than the interest rates which the government needs to pay back. In this situation, the people do not anticipate a tax addition right from the start and their income addition is such, that paying additional taxes in the future does not bother the market. They will not save additional money as their demand increases in a high growth environment.

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