Ricardian Equivalence and Keynesian Macroeconomics

Topics: Deficit, Government debt, Inflation Pages: 9 (3314 words) Published: May 2, 2013
Explain what is meant by the term Ricardian Equivalence. Does it mean that public debt does not matter? Discuss This work outlines the meaning of Ricardian Equivalence and how it suggests that public debt does not matter to either the government or the society that government is representing. A discussion follows stating this may not be the case and why these two parties may have reason to care about public debt. The work then goes onto conclude that there is obvious concern regarding public debt because of the current regime’s primary objective to reduce public sector debt, which alongside criticisms of the Ricardian Equivalence’s assumptions suggest it does not hold in the real world, and that public sector debt matters. Ricardian Equivalence describes David Ricardo’s basic idea that bonds and taxation are an equivalent form of finance for a government’s budget deficit (Hoover, 1988). This theory implies that a bonds-for-tax swap does not lead to the consumer experiencing a wealth effect as they recognise a fall in taxation in the current time-period will lead to an increase in taxation in the future time-period. This prediction causes the individual to increase current saving in order to finance the future taxation liability, and therefore has no overall effect on his/her overall wealth. The idea was resurrected and theorised by Robert Barro in 1974. His model attempted to rectify some of the problems identified by Ricardo himself (see appendix 1) by assuming that individuals have infinitely long lives. This ensured the same individuals who purchased bonds in T1 would be taxed in period T21. A key assumption of the Barro model is that perpetual bond finance is not an option to the government suggesting that it must be paid off at some point in order to make the model plausible. The model’s conclusion is similar to Ricardo’s which is explained in appendix 2. A problem with Barro’s assumption that agents live infinitely is that this in practice is not the case. An agent could avoid the tax payment in T1; die in the interim period between T1 and T2 thus avoiding the tax increase in T2. To address this problem, Barro formulated the ‘Over-Lapping Generations’ model described in Appendix 3. Therefore, having explained and understood what the Ricardian Equivalence is, it assumes that public debt does not matter to the government or society as taxation can always be increased in the future to finance such debt. There are however a number of reasons which suggest this is not true and that both parties are concerned about public debt which shall be discussed in the next part of the work. 1 This theory of Ricardian Equivalence is regarded as the logical completion of the permanent income/life cycle hypothesis which assumes how consumption is determined by long-term average incomes (Seater, 1993) known as their level of ‘Permanent Income’ and not short-term alternations from variables such as taxation changes.

The current austerity measures in the UK are attempting to create revenue that can be used to reduce the levels of public debt. The concern is that if this does not happen, public debt could become explosive as bond interest rates continue to increase meaning credibility may be lost in the government’s solvency preventing new bond issues being purchased on the open market (see Appendix 4). The concern of the current administration in the UK is that government debt therefore does matter as it has the potential to catalyse a series of detrimental consequences. Krugman (2012) criticises this approach suggesting that high amounts of debt relative to GDP do not increase the implied interest-rates on government bonds. This is evident in the UK, as government net debt has increased from 45% to 83% as a percentage of GDP (IMF, 2013) between 2008 and 2012 shown by Figure 3. UK 10 Year Government Bond Yields on the other hand for the same period have decreased from 4.6% in 2008 to1.9% in 2012 (Bank of England, 2013), shown in...
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