Last modified: 2017-05-27
Abstract
The paper discusses the foundations of the so called ‘Ricardian Equivalence’ (RE), according to which Government deficit spending would produce no effects on aggregate demand, due to the offsetting increase in saving decisions by the private sector. Despite it has been the object of several criticisms on both theoretical and empirical grounds, still such ‘neutrality’ of public deficit and debt is often taken as being in principle undisputable inasmuch it would be the result of the rational behaviour of households, which economic analysis generally presupposes. Even in documents of economic institutions such as the ECB one can find that the reaction of agents to deficit spending as implied by RE appears to be taken for granted.
This is why a most effective criticism of RE must question in the first place the alleged rationality of the private sector’s behaviour which lies at the very roots of RE. Basing on arguments put forward in the literature and developing some further ones, the paper maintains that that rationality is lacking in several respects, from either individual or aggregate standpoints. The most specific contributions of the paper consist, in particular, in showing that:
a) imposing the zero value for future public debt, which is a necessary condition for the RE argument, does not generally respond to a maximizing (hence rational) behaviour of private agents;
b) if the level of income is allowed to vary (i.e., full employment is not assumed), private savings would increase, whatever the share of income saved, by the same magnitude of the public deficit, due to the effect of the latter on aggregate demand and output. Therefore for the private sector as a whole, e.g. for the (private) representative agent, it would be self-damaging, hence irrational, to react as predicted by RE, since increasing the share of income saved would only reduce the increase in the level of income from which the same amount of private savings is obtained.