Table of Contents

Ricardo-Barro Effect: Meaning, Arguments Against, Evidence

By

澳洲幸运5官方开奖结果体彩网:Clay Halton

Updated October 07, 2023

Reviewed by

Robert C. Kelly

Fact checked by

Ryan Eichler

What Is the Ricardo-Barro Effect?

The Ricardo-Barro effect, also known as Ricardian equivalence, is an economic theory that suggests that when a government tries to stimulate an economy by increasing debt-financed government spending, demand remains unchanged because the public increases their saving to pay fo💦r expected future tax increases⛦ that will be used to pay off the debt.

Key Takeaways

The Ricardo-Barro effect is an economic theory suggesting that demand remains unchanged when a government tries to stimulate an economy by increasing debt-financed government spending.
The Ricardo-Barro effect was developed by David Ricardo in the 19th century but was revised by Harvard professor Robert Barro later.
According to the Ricardo-Barro effect, demand remains unchanged because when government stimulus spending rises, the public increases their saving to pay for expected future tax increases that will be used to pay off the debt.
The Ricardo-Barro effect is also known as Ricardian equivalence.
Other economic strategies have proven better at increasing consumer demand, such as the lowering of interest rates, which makes the cost of borrowing cheaper.

Understanding the Ricardo-Barro Effect

While the Ricardo-Barro effect was developed by 澳洲幸运5官方开奖结果体彩网:David Ricardo in the 19th century, it was revised by Harvard professor Robert Barro into a more elaborate version of the same concept. His theory stipulates that a person's consumption is determined by the lifetime present value of their after-tax income—their 澳洲幸运5官方开奖结果体彩网:intertemporal budget constraint.

So the government cannot stimulate consumer spending since people assume that whatever is gained now will be offset by higher taxes due in the future. It also implies that no matter how a government chooses to increase spending by borrowing or raising taxes, demand will remain unchanged, because debt-financed public spending will "澳洲幸运5官方开奖结果体彩网:crowd out" private spending.

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Criticisms of the Ricardo-Barro Effect

The major arguments✱ against the Ricardo-Barro effect are due to what are perceived as the unrealistic assumptions on which the theory is based. These assumptions include the existence of perfect capital markets and the ability for ꧋individuals to borrow and save whenever they want. Additionally, there is the assumption that individuals are willing to save for a future tax increase, which they may not see in their lifetime.

There is no evidence that the Ricardo-Barro effect changed saving when the Reagan administration cut taxes and hiked military spending between 1981 and 86. In fact, net private savings as a percentage of GNP fell to 3.3% in Q4 of 1986 from 8.6% in Q3 of 1981.

This also does not ring true today, when the U.S. personal saving rate has fallen to multi-decade lows, even as U.S. government borrowing soars. People just don’t seem to behave in a way that is consistent with Ricardian equivalence. The national 澳洲幸运5官方开奖结果体彩网:savings rate as of Q2 2023 is -0.2%. In Q1 1999 it was 7.3%, in Q1 2007 it was 2.4%, in Q1 2015 it was 4%, and in Q4 2019 it was 2.9%. This whole time government debt has been increasing.

What Is the Crowding Out Effect?

The crowding out effect states that increased government spending reduces or eliminates private sector spending. The gove♋rnment needs money to spend and it gets that money by increasing taꦦxes, which causes the private sector to spend less and save more, hence, government spending crowds out private sector spending.

What Is the Difference Between Keynesian and Ricardian?

Keynesian economics believes to stimulate an eco🌠nomy, a government should increase spending, even if it means the government goes into debt. Ricardian economics believes that increased government spending does not fundamentally change consumer demand, so the increased government spending has little impact.

What Is the Ricardian Comparative Advantage?

The Ricardian comparative a🙈dvantage theory posits that countries will gain an international trade advantage if they focus on producing the goods and services that require the lowest opportunity costs and trade for the goods and services they do not produce. One of the key aspects of this theory is that it stresses relative productivity differences, not absolute productivity differences.

The Bottom Line

The Ricardo-Barro effect shows that government debt spending does not really stimulate the economy because consumer demand does not change. Consumer demand does not change becau🥀se consumers believe that taxes will increase to pay for this increased debt spending, thus, they save their money. Other means have proven better to stimulate the economy by increasing demand, such as lowering interest rates.

Article Sources

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