Ricardo Barro Effect - Explained
What is Ricardian Equivalence?
Written by Jason Gordon
Updated at November 21st, 2023
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What is the Ricardo-Barro Effect?
The Ricardo-Barro Effect, , also known as Ricardian equivalence, is a microeconomic concept that suggests when there is a reduction in government spending and an increase in taxation; in response, households and businesses increase their level of savings to pay for the higher taxes that are expected in future.
In summary, it says, when a government tries to stimulate the economy by increasing the tax rate and reducing its spending, the public will respond by increasing their savings. Thus, the demand remains unchanged.
Back to:ECONOMIC ANALYSIS & MONETARY POLICY
What Introduced the Ricardo-Barro Effect?
The concept of Ricardo-Barro Effect was first introduced by David Ricardo in the 19th century. The concept was further developed by Harvard professor Robert Barro who provided a more elaborate version of the theory.
Further Explanation of the Ricardo-Barro Effect?
According to the theory, the lifetime present value of ones after-tax income (intertemporal budget constraint) determines his or her consumption and spending. So, if the tax rate is increased by the government the spending of the public will reduce. The public will increase its savings in order to afford to pay the higher taxes in the future.
Thus, the Ricardo-Barro Effect argues that a government cannot stimulate consumer demand by increasing debt-financed government spending.
Critiques of the Ricardo-Barro Effect?
Ricardo-Barro effect has been criticized by the economists as it fails to explain certain spending and savings pattern of the public. Economists argue that the theory is based on some unrealistic assumptions.
The theory of Ricardo-Barro effect assumes that a perfect capital market exists, and the individual has the ability to decide when to borrow and save money.
In reality, an individual's decision to borrow or save money depends on a lot of factors and they do not have an absolute freedom to choose.
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