01.10.12

Ricardian Equivalence

Posted in Economics at 12:10 am

Krugman, DeLong, et al really need to hit this one head on.

http://economistsview.typepad.com/economistsview/2012/01/delong-a-note-on-the-ricardian-equivalence-argument-against-stimulus.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+EconomistsView+%28Economist%27s+View+%28EconomistsView%29%29

http://delong.typepad.com/sdj/2012/01/a-note-on-determinants-of-aggregate-demand.html

http://krugman.blogs.nytimes.com/2011/12/26/a-note-on-the-ricardian-equivalence-argument-against-stimulus-slightly-wonkish/

I addressed this in what I thought was a much clearer manner some time ago:

http://www.disequilibria.com/blog/?p=47

To make it easier to grasp, I’ve put it all in one nice, easy to understand graphic:

http://www.disequilibria.com/ppfa.jpg

This diagram is key to understanding the dispute between so called
freshwater economists and saltwater economists.  When the former argue
in favor of Ricardian Equivalence, they are arguing that any increase
in consumption today necessitates a decrease in consumption in the
future.  This is just another side of the argument that an increase in
consumption necessitates an equal decrease in investment or that an
increase in government spending necessitates an equal decrease in in
private sector spending.

Guess what?  They are right IF the economy is operating at capacity
(on the frontier in the above diagram).  They are wrong IF the economy
is operating below capacity (inside the frontier in the above
diagram).

Freshwater economists make the assumption that the economy is always
operating at capacity (on the frontier).  This is also the reason why
they dismiss the Keynesian multiplier out of hand.  For an economy
operating at capacity, there is no multiplier effect, just a crowding
out effect, because the economy is already operating at its limit
given the existing constraints of resources and technology.

In effect, freshwater and saltwater economists are describing two
completely different worlds.  The former are describing a world in
which all available factors of production (labor, capital) are fully
employed.  The latter are describing a world in which there are
unemployed workers and idle capital.  We can save the discussion of
WHY there are unemployed resources for another day.  What matters now
is that we start with a model that describes the world as it is, with
the problem we’re trying to solve not assumed away.