Ricardian Equivalence

Explain Ricardian equivalence, and discuss what implication it might have on the efficacy of expansionary fiscal policy.

Ricardian equivalence states that for a given level of government spending a change in taxes – financed by a deficit – will have no effect on the real economy. It is posited that individuals are forward thinking and rational and realise that a tax break today will have to be paid in the future. Therefore individuals won’t go out and spend this tax cut but will instead save it so that they can smooth consumption.

They will save ΔT.r (tax cut multiplied by real interest rate), acknowledging that the government will have to pay interest on its debt so future taxation will need to incorporate this. [...]

The Costs and Distributional Effects of Unemployment

The classical view on unemployment says that there are only unemployed people who are not able and willing to work at the going wage rate. So if people would accept a lower wage they would find jobs. In this view all unemployment is a short-term problem and the best solution is laissez faire – leave the market to find equilibrium to resolve the issue of unemployment.

If people accept lower wages then the costs of living will fall as firms do not need to charge such high prices, so in fact workers will find the lower wages are acceptable once they start work. [...]