Question

Explain each of the situation as to why they may or may not invalidate the Ricardian Equivalence proposition
a) There is an election for a new government every 3 years, and there are no rules requiring the government budget has to be balanced.
b) Individuals can borrow at an interest that is twice as high as the rate for bank deposits.
c) The country has a system whereby everybody will get exactly the same wage.
d) Individuals cannot save or lend, they have to consume every dollar of their after-tax income.

Answer 1

Ricardian Equivalence:

Proposed by David Ricardo(19th Century). He was of the view that how the consumers will going to change their behavior with the change in the fiscal policy to stimulate the economy. Let's suppose if government cut taxes today then that will the change the behavior of consumer and they will start savings more today such that they can equalize their future, as government can increase the tax in future, so by that they will balance it.

Reasons:

a) If their is election for a new government every 3 years,and there are no rules requiring the government budget has to be balanced, then this statement may not invalidate the Ricardian equivalence proposition as this will not impact fiscal policy, as new government also change the fiscal policy to stimulate the economy, by which consumer will change their pattern.

b) By second statement also, there will be a change in attitude of consumer with the change in fiscal policy. So, it may invalidate the ricardian equivalence.

c) By third statement, we can say that it may invalidate the ricardian equivalence, as the country where everybody will get exactly the same wage, validity and invalidity will depend on his current wage.

d) By fourth statement, we can say that it may invalidate the ricardian equivalence as individuals cannot save and consuming their every dollar after tax income.