Business-cycle and Ricardian-equivalence

The business cycle is an important objective to refer in order to operate an economic policy. Controlling business cycle is a significant policy for government because during the recession, government inevitably have to spend for the social security due to rise in both unemployment rate and the absolute poverty rate i.e. fall in the average income level. These factors are very crucial elements in economy because these factors are (In particular, unemployment is) a lugging indicator in economy. There are two main government demand management policies intervening into the business cycle; the monetary policy and the fiscal policy.

Some economists put priority on the counter-cyclical government expenditure plan. This policy connotes the fiscal policy is effective to control the business cycle. This reason is based on Keynesian theory denoting that the liquidity of money supply by the monetary policy is ineffective. These economists believe that the increase in government expenditure helps to overwhelm economic recession rather than the extra cash flow. Furthermore, the tax cannot be increased during the recession time as tax rise may perpetuate the recession. Therefore, they support to reduce the tax in order to stimulate the economic activity and incur national debt in order to cover the cost for the government expenditure.

By contrast, this point of view has been contradicted by Neoclassical economists. According to the Neoclassical point of view, the tax deduction does not have much impact on economy. The reason is that individuals may prefer save the amount of extra income from tax deduction to predict their extra expenditure for the interest payment for the government debt. This theory is called "Ricardian Equivalence".



Focusing on the graph, individuals prefer spending for consumption at both current and future time at the level of their utility curve. Therefore, although there is an tax deduction it does not have any effect on the current consumption level and eventually they still have to pay the interest payment through taxation in order to pay back for the debt incurred in the past. Thus, Ricardian equivalence states that the fiscal plan should be fixed over time.

Neoclassical theorists put emphasis on the monetary policy and the supply-side reforms in order to tackle with the recession.


Nevertheless, there has been a counter argument against Ricardian equivalence. Some economists argued that Ricardian equivalence might be true if the recession is not serious and the absolute poverty level is lower. Otherwise, tax deduction and
debt incuring are required.



Focusing on the graph above, if individuals have not gained enough income to consume, the extra tax deduction can increase the current consumption level because it expands the borrowing constraint. During the recession, some individuals may face this borrowing constraint which denotes the incapability of their income to both spend and save. Therefore, the Recardian equivalence might be contradicted in terms of the aspect that unless tax deduction and debt incurring take place, it may induce the recession lugging.