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By the end of this section, you will be able to:

  • Apply Ricardian equivalence to evaluate how government borrowing affects private saving
  • Interpret a graphic representation of Ricardian equivalence

A change in government budgets may impact private saving. Imagine that people watch government budgets and adjust their savings accordingly. For example, whenever the government runs a budget deficit, people might reason: “Well, a higher budget deficit means that I’m just going to owe more taxes in the future to pay off all that government borrowing, so I’ll start saving now.” If the government runs budget surpluses, people might reason: “With these budget surpluses (or lower budget deficits), interest rates are falling, so that saving is less attractive. Moreover, with a budget surplus the country will be able to afford a tax cut sometime in the future. I won’t bother saving as much now.”

The theory that rational private households might shift their saving to offset government saving or borrowing is known as Ricardian equivalence    because the idea has intellectual roots in the writings of the early nineteenth-century economist David Ricardo (1772–1823). If Ricardian equivalence holds completely true, then in the national saving and investment identity, any change in budget deficits or budget surpluses would be completely offset by a corresponding change in private saving. As a result, changes in government borrowing would have no effect at all on either physical capital investment or trade balances.

In practice, the private sector only sometimes and partially adjusts its savings behavior to offset government budget deficits and surpluses. [link] shows the patterns of U.S. government budget deficits and surpluses and the rate of private saving—which includes saving by both households and firms—since 1980. The connection between the two is not at all obvious. In the mid-1980s, for example, government budget deficits were quite large, but there is no corresponding surge of private saving. However, when budget deficits turn to surpluses in the late 1990s, there is a simultaneous decline in private saving. When budget deficits get very large in 2008 and 2009, on the other hand, there is some sign of a rise in saving. A variety of statistical studies based on the U.S. experience suggests that when government borrowing increases by $1, private saving rises by about 30 cents. A World Bank study done in the late 1990s, looking at government budgets and private saving behavior in countries around the world, found a similar result.

U.s. budget deficits and private savings

The graph shows that government borrowing and private investment sometimes rise and fall together. For example, between 1980 and 1984 the deficit as a percentage of GDP fell from –5 to –2% and the gross private savings as a percentage of GDP also fell from 22% to 20%. In 2014, the gross private savings as around 20%, and the budget deficit/surplus was closer to –3%.
The theory of Ricardian equivalence suggests that any increase in government borrowing will be offset by additional private saving, while any decrease in government borrowing will be offset by reduced private saving. Sometimes this theory holds true, and sometimes it does not hold true at all. (Source: Bureau of Economic Analysis and Federal Reserve Economic Data)

So private saving does increase to some extent when governments run large budget deficits, and private saving falls when governments reduce deficits or run large budget surpluses. However, the offsetting effects of private saving compared to government borrowing are much less than one-to-one. In addition, this effect can vary a great deal from country to country, from time to time, and over the short run and the long run.

If the funding for a larger budget deficit comes from international financial investors, then a budget deficit may be accompanied by a trade deficit. In some countries, this pattern of a twin deficits    has set the stage for international financial investors first to send their funds to a country and cause an appreciation of its exchange rate and then to pull their funds out and cause a depreciation of the exchange rate and a financial crisis as well. It depends on whether funding comes from international financial investors.

Key concepts and summary

The theory of Ricardian equivalence holds that changes in government borrowing or saving will be offset by changes in private saving. Thus, higher budget deficits will be offset by greater private saving, while larger budget surpluses will be offset by greater private borrowing. If the theory holds true, then changes in government borrowing or saving would have no effect on private investment in physical capital or on the trade balance. However, empirical evidence suggests that the theory holds true only partially.


Illustrate the concept of Ricardian equivalence using the demand and supply of financial capital graph.

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Questions & Answers

A woman has a television set which cost her $800 two years ago. A new set would cost her $1000 and she could sell her television set for $450. What is the opportunity Cost of keeping the old TV?
Murewah Reply
principle of effective demand?
Abubakar Reply
the is the situation in which the need of individuals exceed the available resource. increase in population rate and wrong decision making
esther Reply
what is the different between wants and demand?
wants are what people desire to have but they can live without them and demand is a thing that is most wanted
what are the demand pull inflation
the higher the aggregate level of activity, the larger the proportion of areas and industries which experience excess demand for goods and labour of various sorts , and the more powerful is demand-inflationary pressure . Demand inflation is contrasted with cost inflation , in which price and wage
increases are transmitted from one sector to another. These should be regarded as different aspects of an overal inflation starts , cost inflation explains why inflation once begun is so difficult to stop.
what is the important difference between positive and normative economics
positive economics is the study of how an economy works in practice, as opposed to the theoretical study of how it should run in theory and normative economics is the party of economics that is concerned with how the economy ought to be run.
positive economic deal with fact and also talks about how the economy actually is like while normative economic deal with value judgement and talks about how the economy ought to be like
What is the difference between opportunity cost and choice
opportunity cost are also known as forgun alternative why choice is to select one among alternative
importance of economic
Zakaria Reply
satisfaction of human wants
economics is about to economise . discuss
Angel Reply
Underlines the efficiency aspect. Economise towards what: Economise factors to reach equal distribution of Material wealth or Just to operate optimally to Service demand, i. e. Run markets efficiently?
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abba Reply
Hi I'm Ashnly Parker.
what is terms of trade
Ibrahim Reply
different btn import and export
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Gbenga Reply
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scarcity is not necessarily a problem but a constant condition of the world. there are not enough resources to satisfy the unlimited wants.
wee need to be cooperative
by unlimited resourses and abundant want
What is the economic problem
And what is demand pull inflation
why do compute GDP?
steven Reply
can anyone shortly determine the word inflation.
Ibrahim Reply
Continous increase in the general level of prices or in the cost of living.
persistent increased in general price level
all correct...
rise in price.
deserving of money
A persistent tendency for nominal prices to increase
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the father of economics
Reuben Reply
Adem smith
Adem smith
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the father of economic regarding to adam Smith
the father of political of economic and capitalism in his book and inquary in to the wealth of the nation.
Adam Smith his the father of economic
difference between injection and leakage
what is monopoly
Monopoly is a market structure where there is one firm who dominate the industry
hi,, I am new here. please welcome me.
you are welcome
monopoly is the one characterized by a mkt power in which a firm is a price maker
Some member just ask questions but not answering so y this happen
Monopoly is a market where only one seller exists. No competition
how long does the patent right prevail the monopoly
no attempt
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anybody to attempt
Hi, I'm a new member please will you welcome me
different types of price elasticity of demand with the aid of graphs
Tshepo Reply
what about mean median and mode
Dike Reply
mode is the most occurred number and median is the middle digit
the mean is the sum of all the data divided by the number eg: 2+4+4+5+3+5+1 =24÷7
what is exchange rate
thanks guys
What is Equilibrium?
that when supply equals demand. that's where the supply curve and the demand curve intercept.
equilibrium is when the both side of the price is balanced
Thanks Asuquo Agwuu
what is paradox Of drift
doris Reply
it's thrift not drift
so what is it sir
what are the causes of unemployment
Afful Reply
lack of job in the rural areas
High level of illiteracy
Unfulfilled government promises
this one no be problem waii
low rate of industrialisation

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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