Ricardian Equivalence Theorem – Economics

David Ricardo – one of the most important economists. Ricardo developed a model with the theory of comparative cost advantage – Interjection by Valentin Markus Schulte, economist, Berlin. 

David Ricardo (1772-1823) was a British economist and one of the representatives of the classical economics. His most important theory is the theory of comparative cost advantage. A theory by and large that division of labour leads to a worthwhile trade for all nations. Every nation, according to theory, produces the good which can be produced more efficiently. All other goods are sourced from abroad, are imported. 

Model of Ricardian equivalence 

David Ricardo has developed the model of Ricardian equivalence. This model implies that budget constraint on households is meaningless whether the state finances itself through borrowing or tax revenues. This results from the formula of the Ricardian equivalence, which results from the budgets restriction of the households and the budget constraint of the state. This model, like most economic models, has strict assumptions. The economy considered is an equipment economy, there is no investment, the same interest rate applies to the private and public sector and there is no population growth. 

Budget constraint of households: C1 + C2/1 + r = Y1-T1 + Y2-T2/1 + r 

  C: Consumption of the household 

Y: Revenues of the household 

T: tax 

r: interest rate 

Budget Restriction of the State: G1 + G2/1 + r = T1 + T2/1 + r 

 G: Government expenditure 

T: tax collection 

Summarizing these two formulas creates the formula of Ricardian equivalence: 

C1 + C2/1 + r = Y1-G1 + Y2-G2/1 + r 

Conclusion: Why was Ricardo’s theory rejected? 

Ricardian equivalence failed because of its strict and unrealistic assumptions. In every state of this world, there is a constant change in the population. Besides, there are no perfect credit markets. There is a big difference between the interest rate of the private sector and that of the public sector. Even empirical studies show that this theory is not always transferable to reality. David Ricardo later distanced himself from his own theory and rejected it. Nonetheless, Ricardian equivalence is an interesting model that provides an explanation for budget constraints on households and the state. 

Kurze Zusammenfassung:  

Der britische Wirtschaftswissenschaftler David Ricardo hat das Modell der Ricardianischen Äquivalenz entwickelt. Dieses Modell besagt, dass es für die Budgetrestriktion der privaten Haushalte bedeutungslos ist ob sich der Staat über Kreditaufnahme oder Steuereinnahmen finanziert. Das ergibt sich aus der Formel der Ricardianischen Äquivalenz, welche sich aus der Budgetrestriktion der Haushalte und der Budgetrestriktion des Staates ergibt. 

V.i.S.d.P.:  

Valentin Markus Schulte  

Economist  B.Sc.

Valentin Markus Schulte is a graduate of the University of Potsdam with a degree in economics in 2019. In addition to his master’s degree in economics, he is an author and blogger. He is particularly interested in the international financial markets. Moreover, competition politics and the historical development of economics inspire him with their theories. 

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