Friday, June 13, 2008

No Ricardian Equivalence

While much of the news about the U.S. economy yesterday were bearish, with unemployment benefit claims reaching a new high for this cycle and with import prices soaring, the retail sales report was relatively strong.

This strength arguably reflects the fact that most of the so-called tax rebate checks were sent out that month. There are two implications of this, one with regard to the assessment of the U.S. economy and one for economic theory. Regarding the economy, this could provide some support for second quarter GDP, although this will to some extent be cancelled out by a higher trade deficit.

The implication for economic theory is, as Greg Mankiw points out, that Ricardian equivalence is again falsified. Consumers didn't seem to care very much that this extra income is only temporary and came at the price of a higher government budget deficit, and seems to have spent much of it. This result should not surprise anyone. Ricardian equivalence rests on a number of assumptions which are false, such as a general belief that the government would have to pay back its debts or that interest rates are equal to general time preferences.


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