Does Ricardian Equivalence Hold With When Borrowing Constraints Are Binding?
Ricardian Equivalence, also known as Ricardo-De Viti-Barro Equivalence theorem, is an economics hypothesis stating that an increase in government borrowing to finance their spending may have no impact on consumer spending and aggregate demand. This is because consumers predict tax cuts or higher government spending to stimulate the economy will result in future taxes increase to pay back the debt. Therefore whatever they gain now will be offset by future taxes raise. Assumptions under Ricardian Equivalence are:
Consumers are rational and farsighted
They live forever and (or) care about their ancestors as much as they care about themselves
They believe that current budget deficits imply future tax increase
Households are homogenous
No liquidity constraints
Capital markets are perfect
The concept of Ricardian Equivalence is criticized to be impractical as we cannot assure that the vast minority of consumers are rational and care about their next generations as much as they care about themselves. Even if consumers care about the tax burden for next generation occurred from the current budget deficit, they can argue that the increase in population will redistribute taxes and their children will not be in difficulties with paying back.
Liquidity constraints are needed to be eliminated in order for Ricardian Equivalence to hold. To explain this, consider this example. If consumer A wishes to…