Ricardian Equivalence

The Basic Idea

The Ricardian Equivalence states that given two utility functions, U1(c1, U2(c2)) and U2(c2), and two different time periods, period 1 and period 2, the optimal division of consumption (c1*, c2*) will not change from period 1 to period 2 even with an increase to the total available for consumption.

Example Illustrating the Ricardian Equivalence

The example Akerlof uses to describe this relationship is the bequeathing of a social security payment from parent to child. In the example, the parent (U1) chooses his/her utility maximizing consumption (c1*) during period 1; what is left of total consumption is bequeathed to the child (c2*). Now imagine that the government gives a transfer payment in the form of a social security payment to the parent during period 1, but then taxes the child during period 2. The affect of the social security payment is then nullified. The optimal consumption in period 1 remains the optimal consumption for period 2 even with the transfer payment.

The Role of Norms

People view the bequest of a monetary sum as a type of gift. Gifts are governed by norms associated with the amount that is appropriate no matter the circumstances. With the fulfillment or lack of fulfillment of these norms, comes increased or decreased utility respectively. In essence, the parent gains added utility by fulfilling what he/she believes is an appropriate gift given the norms of the society.

Effect of Norms on the Ricardian Equivalence

With norms introduced to the parent’s utility function, the transfer payment is no longer neutral. The equilibrium amount of the bequest is changed because the parent now associates the payment as his/her own. With a given consumption augmented by the amount of the transfer payment, the parent will now give a larger bequest to the child the larger the transfer payment. The bequest will not increase proportionately to the transfer payment, however, because the parent will seek to maximize his/her own utility by consuming part of the transfer payment, thus changing the optimal amount of consumption between the periods. In theory, when norms are introduced, the neutrality of the transfer payment as proposed by the Ricardians will not hold.

Reasons Why Ricardian Equivalence is not Empirically Correct

The following refer to constraints, independent of the parent’s preferences, and are seen as frictions within the economy:

• Infinite, rather than finite, horizons
• Strategic bequests to obtain the attention of one’s heirs while alive
• Childless families
• Uncertainty, including bequests made because of uncertainty about the age of death
• Differential borrowing rates between the government and the public
• Growth of the economy in excess of the interest rate allowing steady debt issuance
• Lack of foresight regarding the effect of social security on future taxes
• Foreign ownership of debt
• Tax distortions

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