What Is Ricardian Equivalence?

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[Narrator] What is
Ricardian equivalence?

Named after David Ricardo,
a 19th century British economist,

Ricardian equivalence is a scenario
in which consumers respond

to changes in fiscal policy

in ways that make
fiscal policy less effective.

If the government cuts taxes
to stimulate the economy,

people might then choose
to save the tax cut

instead of spending it.

Now saving money from a tax cut
actually makes a lot of sense

if people expect that
tax cuts today will be matched

by tax increases tomorrow.

However, if people save
their tax cuts

instead of spending them,
then the aggregate demand curve

never shifts out,
the multiplier will be zero,

and there will be no systematic
macroeconomic effects.

Most economists think
Ricardian equivalence

is imperfect and that it's somewhat
unrealistic to model everyone

as fully rational in incorporating
their future tax burdens

when making saving
and spending decisions.

So Ricardian equivalence probably
describes some people,

maybe not most people.

In any case, to the extent
that Ricardian equivalence reflects

how people plan, tax cuts will be
less effective as fiscal stimulus

than they otherwise would be.

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To learn more about the reality
of implementing fiscal policy,

click here.

Or, test your knowledge
on Ricardian equivalence here.

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