Tuesday, March 16, 2010

Ricardian Equivalence Holding

For Ricardian Equivalence to hold, fiscal policy must be exogeneous and that can only occur if it is unexpected; if it is expected then such policy actions will have already been anticipated and incorporated into actions. Ricardian Equivalence cannot hold for an event it is already holding for. The problem here is the government action is not exogeneous because it is anticipated, but rather than an argument against stimulus, it is an argument that the government has no choice but to stimulate because that is what is expected of it. If government starts raising taxes during a recession or cuts spending during a surplus, pays down debt during a recession, or increases borrowing during a boom, it may hold, otherwise there is nothing unexpected about such actions and they do not constitute an exogeneous event. After more than a half century of Keynesian stimulus, the idea fiscal stimulus can be unexpected is incredulous. Rather, lack of stimulus would be unexpected forcing people to modify their behavior accordingly if they are capable of doing so, which they may not be able to if they are credit constrained. The real surprise may be that combining state and federal spending, there has been no stimulus.

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