Question

Explain the content of the Ricardian Equivalence Theorem and its implications. Discuss whether the theorem is likely to hold in practice.

Answer 1

• Meaning and Explanation : According to Ricardian Equivalence, government spending funded through the borrowing does not increase aggregate demand in economy. There is no difference whether spending is funded through the tax or borrowing. Increase in public debt in form of borrowing would be correctly anticipated by the people. Hence people would anticipate that government is going to increases taxes in near future pay off debts. Hence, they will reduce current spending and save more for paying future taxes.
• Implications: Thus, government spending would not help to get economy out of recession. Increase in spending funded by debt would increase saving by people to payoff future taxes.
• Practical experiences: practical experience suggest opposite results. According to Keynesian economics, during the recession government spending funded through the borrowing and tax cut would help to increase aggregate demand in economy which assists in tackling problem of recession.