This episode of Economics Explored explores the theory of Ricardian equivalence, a proposition that fiscal policy measures like tax cuts or stimulus payments may not effectively boost the economy if households anticipate higher future taxes to pay off government debt. Host Gene Tunny explains the concept originating from David Ricardo and popularized by Robert Barro, involving ultra-rational consumer optimization over infinite time horizons. While an elegant theoretical model, Ricardian equivalence relies on unrealistic assumptions and fails empirical tests. Evidence shows households do increase spending after rebates or transfers, although not always by as much as policy makers would like. Ultimately, while the merits of discretionary fiscal policy are debatable, Ricardian equivalence is too extreme a hypothesis. Households do not behave as ultra-rational dynamic optimizing models predict.
This episode of Economics Explored explores the theory of Ricardian equivalence, a proposition that fiscal policy measures like tax cuts or stimulus payments may not effectively boost the economy if households anticipate higher future taxes to pay off government debt. Host Gene Tunny explains the concept originating from David Ricardo and popularized by Robert Barro, involving ultra-rational consumer optimization over infinite time horizons. While an elegant theoretical model, Ricardian equivalence relies on unrealistic assumptions and fails empirical tests. Evidence shows households do increase spending after rebates or transfers, although not always by as much as policy makers would like. Ultimately, while the merits of discretionary fiscal policy are debatable, Ricardian equivalence is too extreme a hypothesis. Households do not behave as ultra-rational dynamic optimizing models predict.
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Takeaways
Five takeaways from this episode are:
1. Ricardian equivalence is an elegant theoretical model but relies on unrealistic assumptions about rational consumer behavior.
2. Empirical evidence overwhelmingly finds that households do increase spending after tax rebates or fiscal stimulus, contrary to Ricardian equivalence predictions.
3. Related concepts like Friedman's permanent income hypothesis are more nuanced but also face limitations in fully explaining consumer decisions.
4. While fiscal policy faces challenges, Ricardian equivalence is not a compelling argument against its effectiveness due to failures of the underlying theory.
5. Examining economic models against real-world evidence is important for evaluating their validity and implications for policy.
Timestamps
Links
Previous episode in which Ricardian Equivalence was mentioned:
Robert Barro’s 1974 article “Are Government Bonds Net Wealth?”
https://eml.berkeley.edu/~saez/course131/Barro74JPE.pdf
James M. Buchanan on “Barro on the Ricardian Equivalence Theorem”
https://www.journals.uchicago.edu/doi/abs/10.1086/260436
Geoffrey Brennan and James M. Buchanan on “The Logic of the Ricardian Equivalence Theorem”
https://www.jstor.org/stable/40911555
John J. Seater on “Ricardian Equivalence”
https://www.jstor.org/stable/2728152
T. D. Stanley on “New Wine in Old Bottles: A Meta-Analysis of Ricardian Equivalence”
https://www.jstor.org/stable/1060788
Economist 2008 column “Ricardian equivalence is dead”
https://www.economist.com/free-exchange/2008/05/19/ricardian-equivalence-is-dead
Anrdrew Leigh’s paper “How Much Did the 2009 Australian Fiscal Stimulus Boost Demand? Evidence from Household-Reported Spending Effects”
http://andrewleigh.org/pdf/FiscalStimulus.pdf
Matthew D. Shapiro & Joel B. Slemrod’s study “Did the 2008 Tax Rebates Stimulate Spending?”
https://www.nber.org/papers/w14753
Claudia R. Sahm, Matthew D. Shapiro and Joel Slemrod’s analysis “Check in the Mail or More in the Paycheck: Does the Effectiveness of Fiscal Stimulus Depend on How It Is Delivered?”
https://www.aeaweb.org/articles?id=10.1257/pol.4.3.216
Ikuo Saito’s paper “Fading Ricardian Equivalence in Ageing Japan”
Thanks to Obsidian Productions for mixing the episode and to the show’s sponsor, Gene’s consultancy business www.adepteconomics.com.au. Full transcripts are available a few days after the episode is first published at www.economicsexplored.com. Economics Explored is available via Apple Podcasts, Google Podcast, and other podcasting platforms.