"Ricardian Equivalence"--a theory not believed in by David Ricardo--is the claim that when the government cuts lump-sum taxes or increases lump-sum transfers in the present and balances this by a credible announcement that it will increase lump-sum taxes in the future such a shift in the economy has no effect on spending, prices, production, or interest rates. For Ricardian Equivalence to hold, we need for:
- people to be able to borrow and lend as much as they want at the market interest rate.
- people to be your standard non-myopic economic agents.
- people to care only about the subjective utility of their descendants.
- everybody to leave a positive bequest to each of their descendants.
- everybody to have some descendants.
- nobody immigrates or emigrates.
To the extent that people cannot borrow and lend at the market interest rate, that people are myopic, that people care about descendants in other ways than seeking to maximize their subjective utility, that people don't leave bequests to all their descendants, that people don't have descendants, and that people immigrate or emigrate, Ricardian Equivalence will fail. How much it will fail depends on the magnitudes, etc., but fail it does.
John Cochrane writes:
The Grumpy Economist: "Ricardian Equivalence," which is the theorem that stimulus does not work in a well-functioning economy
This definition of a "well-functioning economy" is not something I understand.
In a well-functioning economy, it is usually the case that people immigrate and emigrate, die childless, disinherit individual descendants, care about their descendants in other ways than seeking to maximize their subjective utility, cannot borrow and lend unlimited amounts at the market interest rate, etc., etc. Yet the fact that these things hold--things that break Ricardian Equivalence--does not mean that the economy is not well-functioning.
You might as well say that in a well-functioning capital market, it doesn't matter how much debt a firm issues because the Modigliani-Miller Theorem tells us that if a firm sells bonds and buys stock investors can still maintain the same ownership stake in the firm by buying the newly-issued bonds as they sell some of their stock back to the firm. This misses the point entirely. Many capital markets that I would call well-functioning are markets in which Modigliani-Miller fails.
Indeed, I cannot think of a capital market I would call well-functioning in which Modigliani-Miller holds.