Ricardian Equivalence - Essay Example

? Ricardian Equivalence Ricardian Equivalence Ricardian equivalence is an economic theory that was developed to equip individuals with pertinent information regarding government spending and management of public debt. The theory indicates that consumers in various settings are continually focusing on budget constraints within their nations. This enables them to prepare adequately to counter the effects of tax changes. Preparation ensures that they are not affected by tax changes that may impede their demand power or purchasing propensity. The theory has been instrumental in building confidence among stakeholders in various nations because it discredits any possible effect that public debt may present. It suggests that debt management systems that a government uses cannot affect the total demand in an economy. As a result, the public will continuously save its excess monetary incentives to cater for the future increase in tax obligation. The theory has been instrumental in several nations including US in the management of economic complications such as inflation. It provides basic incentives and guidelines that enable investors in various economies to embrace the applications. However, it has been exposed to criticism from various scholars and individuals who question credibility. The stakeholders state that the theory is full of suppositions and assumptions but lack factual guidelines. They affirm that it cannot provide factual solutions to the current economic dynamics. The meaning of Ricardian Equivalence, discussion on public debit and its relevance to economist Ricardian equivalence theory holds that consumers in various economic set ups are continuously internalizing their government budget constraints. Economically, the theory has real budget constraints and functions that represent expenditure in various fiscal or economic periods as determined by a government. Normally, the constraints are given in two periods (period1 and 2). They give a credible procedure of how government expenditure is arrived at and how key functions that include interest rate and value of holdings affect expenditure rates. g1 + b1 = (1+r) b0 + t1 and g2 + b2 = (1+r) b1 + t2. As indicated g1 and g2 are key denotations of government spending in both periods while t1 and t2 denote real tax revenue that a government is able to collect within the periods. Consequently, b0, b1 and b2 represent the value of the real asset holdings that a government has at the end of the periods. As usual r represent the real interest rate between the fiscal periods or period one and two respectively. These constrains gives a clear understanding on how government expenditure and allocation of resources is done. It also facilitates the understanding of the contribution of each element in calculating government expenditure. This empowers them to evade the effects of any tax changes that may obstruct their spending competence. Tax variations do not affect demand levels because consumers make adequate preparations to counter the effects of tax increases. The theory suggests that it is no longer an economic issue if an administration finances its costs with debt or tax raise (Ghosh & Ghosh 2008 p. 279). This is recommendable according to the theory because the sources of finance cannot affect the level of demand for various securities and other commodities in a fiscal system. This explains why public debt remains a key source of debt finance. It ensures that consumers are cushioned from the effects of economic hostilities. Indeed, the theory emphasizes the imperativeness of debt financing and increase in taxation in ensuring the achievement of balanced economy. Its development enabled economists to manage the balance of recompense deficit effectively. This is essential in ensuring that a country operates within its limits and strengthens its internal resource enlistment sectors. It also ensures that consumers and investors continuously study how budget is run, and make capital reserve for future tax increases (Ghosh & Ghosh 2008 p. 280). The basic idea behind the theory explaining that public debt matters is that public finance does not affect demand. Ricardo stated in the theory that economic results will remain unchanged regardless of whether a government chooses to increase spending with tax increase or debt financing. The outcome will be the same and the demand for various economic goods will be unchanged in the near future. Public debit, also known as government debit does matter especially within the United States. This credible source of finance attracts limited interest rates. Governments usually borrow from its citizens through structured finance mobilization channels such as issuing of government bonds and securities. The identified portfolios enable governments to raise funds to support the execution of local processes with limited complications. High tax rates and debt mobilization also eliminate budget constraints by ensuring effective mitigation of financial deficits that a country may face (Bayoumi & Masson, 1998, P, 4). Individuals are advised to monitor the economic trend in a nation to identify possible changes in tax rates. This is essential in ensuring that the make necessary adjustments and reserves to cushion them from the effects of tax changes. Discussion on the significance of government debit Ricardian equivalence theory does not hold the view that government debit is not importance. It holds that government debit is a key source of financial mobilization or source of finance that governments can use to acquire local funds effectively. It enables authorities to manage financial inflows and outflows in a nation. It also ensures proper control of monetary resources that leads to effective mitigation of inflation. Governments use debt financing as a strategy to correct the imbalance between supply and demand of money (Bayoumi & Masson, 1998 p. 6). This is achievable by putting the requisite monetary control measures. The strategy is significant because it seeks to correct inflationary gap by creating a balance between expenditure and demand propensity of individuals. This helps in eradicating the effects of market externalities that holds the capacity of stalling growth. In particular, it ensures that price ceiling and price floor externalities are well managed to avert possible constraints that may stall demand and supply of commodities. The idea also enables governments to plan effective techniques of enhancing investment, ensure adoption of viable fiscal policies and reduction of inflation (Wheeler, 2004, P, 2). This has been instrumental in most settings because management of inflation is critical for development. The idea has achieved this objective by ensuring effective withdrawal of excess resources from the public through debt or borrowings by offering government bonds and securities. This has ensured proper monetary control in nearly all nations. Models and the assumptions of the theory Although the theory states that the two sources of finance do not affect total demand for various valuables in the economy, they affect the value of interest rates. Increase in taxation holds proportional effect on the value of interest rate levied on products. Consequently, increase in debt financing comes with high interest obligation that consumers must meet (Kumhof & Tanner 2005 p. 3). Critics of the idea are of the opinion that the theory is based on unrealistic presumptions and assumptions that may not support economic development. The assumptions include the existence of perfect capital markets in diverse economic blocks and the ability for individuals to make borrowings and savings at will. The assumption that individuals will always be willing to save for future increase in tax obligations is unrealistic. The critics state that the theory is based on detrimental assumptions that erode its credibility and relevance in the current society. It is asserted that nation where individuals make monetary reserve to cater for tax increases are missing (Hyman, 2008, P, 205). This is difficult to attain especially in the existing economic environment where individuals are facing dynamic challenges. In real scenario, total amount of taxes that are paid is dependent on the consumption level of individuals in a particular period if taxation is discretionary levied. Although, it does not influence demand or consumers spending so much, the tax rate influences choices that are made by consumers. This is because discretionary tax policies affect the slope of consumers LBC than Ricardians theory that is dependent on lump sum taxation. The lump sum taxation does not depend on the choices that made by consumers (Hyman, 2008, p. 205). It assumes that consumers make choices out of unspecified guidelines that limit their risk level as shown below. Snar(r) 1(r) Savings and investment Explanation of graph The two axes represent savings and investment, as well as the proportional increase in the interest rates. It is clear that increase on tax rates present proportional effect on interest rates represented with the curve marked (r). This leads to low investment because it is a function of negative function of interest rate. It also leads to crowding that is a product of monetary imbalance. This occurs when tax revenues decline with unchanged government spending (Greiner & Fincke, 2009, p.56). This explains why assumptions of the theory may not be correct or pertinent in various settings. Consequently, private savings of individuals is a relatively increasing function of real interest rate. This is because the government is independent of the interest rate. It is evident that national savings is an increasing function of the real interest rate. This is clear in the diagram below where the equilibrium is achievable when proper balance or management of interest rate is affected. The savings and investment seem to meet at an ideal location that is proportionate to the rate. This often happens when the government engages in the standardization process. Snar (r) 1(r) Savings and investment Conclusion The theory has been instrumental in building confidence between stakeholders in various nations. This is because it seeks to discredit possible effects that public debt may present to individuals. It also assures stakeholders in various economic blocks that the sources of finance or debt management that a government uses cannot affect the total demand in an economy. This is vital in ensuring sustainable financial growth through debt financing. List of References Bayoumi, T., & Masson, P. R. 1998, Liability-creating versus non-liability creating fiscal stabilization policies: ricardian equivalence, fiscal stabilization, and EMU, London, Centre for Economic Policy Research. Greiner, A., & Fincke, B 2009, Public debt and economic growth, Dordrecht, Springer. Ghosh, A., & Ghosh, C 2008, Economics of the public sector, New Delhi, Prentice-Hall of India. Hyman, D 2008, Public finance: a contemporary application of theory to policy, Mason, OH, Thomson/South-Western. Kumhof, M., & Tanner, E 2005, Government debt: a key role in financial intermediation, Washington, DC, IMF. Wheeler, G 2004, Sound practice in government debt management, Washington, D.C, World Bank. Read More