What claim is made by the Ricardian Equivalence Theorem? Why must it hold in a simple economy? If it fails to hold for our economy, what do economists expect the reason(s) may be?

Question

What will be an ideal response?

Answer 1

The Ricardian Equivalence Theorem states that government borrowing has no effect on people's wealth, which in turn implies that it has no effect on either the demand for current consumption or the interest rate. In a simple economic framework, the Ricardian Equivalence Theorem must hold. When a consumer can borrow or lend at the market interest rate, his budget line is the same whether he is taxed $1 today or $1 plus interest tomorrow. If the Ricardian Equivalence Theorem does not hold in our economy, most economists believe it must be due to either misperceptions or default risk. When misperceptions are prevalent, people do not believe that government borrowing today will cause higher taxes tomorrow. Thus, government debt "fools" people into thinking that their endowments are higher than they really are, which increases the demand for current consumption and the interest rate. When default risk is prevalent, people must pay higher interest rates than the government. In this situation, government borrowing provides a more favorable budget for consumers than current taxation, which increases the demand for current consumption and the interest rate.