Ricardo-Barro Effect

What Is the Ricardo-Barro Effect?

The Ricardo-Barro effect, otherwise called Ricardian equivalence, is an economic theory that recommends that when a government attempts to invigorate an economy by expanding debt-supported government spending, demand stays unchanged, on the grounds that the public increases their saving to pay for expected future tax increases that will be utilized to pay off the debt.

Grasping Ricardo-Barro Effect

While the Ricardo-Barro effect was developed by David Ricardo in the nineteenth century, it was changed by Harvard teacher Robert Barro into a more elaborate form of a similar concept. His theory specifies that an individual's not set in stone by the lifetime present value of his after-tax pay — their intertemporal budget constraint.

Thus, government can't animate consumer spending since individuals accept that whatever is acquired now will be offset by higher taxes due from now on. It likewise infers that regardless of how a government decides to increase spending by borrowing or increasing government rates, demand will stay unchanged, on the grounds that debt-supported public spending will "crowd out" private spending.

Contentions Against the Ricardo-Barro Effect

The major contentions against the Ricardo-Barro effect are due to what are perceived as the ridiculous assumptions on which the theory is based. These assumptions incorporate the presence of perfect capital markets and the ability for people to borrow and save at whatever point they need. Furthermore, there is the assumption that people will put something aside for a future tax increase, which they may not see it in their lifetime. This doesn't ring true today, when U.S. personal saving rate has fallen to multi-decade lows, even as U.S. government borrowing takes off. Individuals just don't appear to act in a manner that is predictable with Ricardian equivalence.

The Eurozone Provides Some Evidence of Ricardian Equivalence

There is no evidence that the Ricardo-Barro effect changed saving when the Reagan administration cut taxes and climbed military spending between 1981-85. As a matter of fact, net private saving as a percentage of GNP tumbled to 7.47% during the 1981-86 period, from 8.5% in 1976-80. The eurozone financial crisis has given an evidence to support Ricardian equivalence. In light of data from 2007, there is a strong correlation between government debt weights and changes in families' financial assets for 12 of the 15 countries inside the union.