Jeremy Bulow and Paul Klemperer: Reorganizing the Banks
The Geithner Plan FAQ

Ricardian Consumers and Fiscal Policy Once Again

John Cochrane wrote:

Economist Debates: Keynesian principles: The basic Keynesian analysis... is simply wrong. Professional economists abandoned it 30 years ago when Bob Lucas, Tom Sargent and Ed Prescott pointed out its logical inconsistencies.... Robert Barro's Ricardian equivalence theorem was one nail in the coffin. This theorem says that [fiscal] stimulus cannot work because people know their taxes must rise in the future...

Kevin Quinn comments:

This is surely disingenuous on Cochrane's part - I hope it is, at any rate. Ricardian equivalence, it is true, implies that deficit-financed tax cuts cannot affect demand. Deficit-financed temporary increases in Government spending, on the other hand, can. Consumption falls today, because the present value of future taxes is higher by the amount of the spending increase, but not by as much as G rises. The reduction in the present value of life-time income implies that the [present value of the] sum of reductions in current and future consumption will be equal to the increase in G, so the reduction today will be small.

Moreover, if the spending is for public investment with a return equal to the private rate of return, life-time income is unaffected and there is no fall in consumption at all. And if the rate of return is greater than the private return, C will increase along with G!...

One of the strangest and most bizarre misconceptions of the modern Chicago School is this belief: that because in Ricardian-equivalence situations tax changes do not affect aggregate demand that Ricardian-equivalence means that government purchase changes do not affect aggregate demand either. As Kevin explains, that is simply not the case. And I cannot imagine how anybody could have ever concluded that it was the case.