What is Ricardian equivalence? According to the Ricardian view of government debt, how does a debt-financed...

What is Ricardian equivalence? According to the Ricardian view of government debt, how does a debt-financed tax cut affect public saving, private saving, and national saving? What is one reason that Ricardian equivalence might not hold?

Expert Solution

The Ricardian equivalence an economic theory – proposed by David Ricardo ,a political economis in 19th century according to which when the government tries to stimulate the economy through increase in debt-financed government spending, it will have no effect on demand as consumers are assumed to be rational / forward looking so they know that debt financed expenditure today means higher taxes in future so they internalise this knowledge while making their consumption decisions . Therefore the aggregate demand does not increase when debt financed tax cut occurs .

This means that public saving will decrease while the private saving will increase and national saving remains same .

Ricardian equivalence may not always hold because all consumers do not always act rational i.e everyone does not imply a tax cut today means higher tax tomorrow . Also uncertainty may affect the behaviour of individuals . Also factors like population and economic growth have not been taken into account .

Rahul Sunny answered 2 years ago

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