Question

Explain the concept of Ricardian equivalence.

Answer 1

In simple words, the Ricardian equivalence is a hypothesis in economics, which states that consumers are generally forward-looking and they consider the budget constraint of the government while making their own consumption decision. In other words, for a given pattern of government spending, the government decisions to finance it expenses does not affect the consumption decisions of people, so the aggregate demand remains unchanged.

For example, if the government reduces taxes and finance its expenses through bonds, people will consider this decision of the government and reduce their consumption at present with the anticipation of a rise in tax in the future. Therefore, the effect on the aggregate would be the same as it would have had the government chosen a higher tax rate at present.