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Sunday, March 13, 2011

Even More on Ricardian Equivalence

There are more discussions of Ricardian equivalence today:

Williamson says:

A hardcore Keynesian wants you to think that Ricardian equivalence is a pretty flimsy idea, but it's not.

That's one opinion. Here's another from David Romer's graduate level Advanced Macroeconomics text. He may or may not be a "hardcore Keynesian," I'll leave that to him, but I'd prefer to let theory and evidence trump labels:

"there is little reason to expect Ricardian equivalence to provide a good first approximation in practice"

The relevant section from the text is provided in the link. Romer provides mostly theoretical objections, but I want to note one thing that Williamson left out, the empirical evidence for this proposition is mixed at best. Again, from Romer:

11.3 Ricardian Equivalence in Practice ...The issue of whether Ricardian equivalence is a good approximation is closely connected with the issue of whether the permanent-income hypothesis provides a good description of consumption behavior. ...

We saw in Chapter 7 that the permanent-income hypothesis fails in important ways... This ... suggests that there is little reason to expect Ricardian equivalence to provide a good first approximation in practice. The Ricardian equivalence result rests on the permanent-income hypothesis, and the permanent-income hypothesis fails in quantitatively important ways. ...

To be fair, the empirical evidence does provide support in some cases -- as noted here, "When Ricardian equivalence is tested in a life–cycle framework the hypothesis is usually rejected, while when the empirical analysis is based on optimizing models, it is usually accepted. But my reading of the evidence is that it would be hard to justify anything more than a 50% offset even when the conditions for Ricardian equivalence appear to be well approximated. As I said when this topic initially came up, worries about Ricardian equivalence may justify a larger policy intervention, taking the extreme case if there is a 50% offset than the policy needs to be twice as large (or, better, structured in such a way as to minimize the offset), but it shouldn't lead to a worry that these policies won't work at all. (And to the extent that the tax cuts are partly saved, when liquidity/borrowing constraints are present for some households the money held against future tax liabilities can provide important insurance against unexpected contingencies. This allows households to resume consumption sooner than they would have without this insurance.)

    Posted by on Sunday, March 13, 2011 at 02:25 PM in Economics, Taxes | Permalink  Comments (13)


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