31.3 How Government Borrowing Affects Private Saving

Government borrowing and private saving are interconnected in unexpected ways. The Ricardian equivalence theory suggests that when the government borrows more, people save more to prepare for future tax hikes. This could make fiscal policy less effective at boosting the economy.

Economists have studied this relationship using graphs and real-world data. While some evidence supports the theory, other factors like credit limits and short-term thinking can weaken the link. Understanding this connection helps explain how government actions affect personal finances.

Government Borrowing and Private Saving

Ricardian equivalence theory

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• Government borrowing seen as deferred taxation
• Households anticipate future tax increases to pay off government debt increase their savings to prepare
• Changes in government borrowing offset by equal changes in private saving
• Fiscal policy ineffective in stimulating aggregate demand
• Government budget deficits do not lead to crowding out of private investment

Graphical analysis

• X-axis: Government budget balance (deficit or surplus)
• Y-axis: Private saving rate
• Positive relationship between government budget deficits and private saving rates predicted by Ricardian equivalence
  • Government budget deficit increases, private saving rate rises
  • Government budget surplus increases, private saving rate falls
• Slope of line represents degree of Ricardian equivalence
  • Slope of 1 indicates perfect Ricardian equivalence ($1 increase in government borrowing leads to$1 increase in private saving)
  • Slope between 0 and 1 suggests partial Ricardian equivalence
  • Slope of 0 implies no Ricardian equivalence (government borrowing has no effect on private saving)

Empirical evidence

• Mixed and inconclusive results from empirical studies
• Some studies find evidence supporting Ricardian equivalence, others find little or no support
• Factors affecting validity of Ricardian equivalence
  • Liquidity constraints limit households' ability to increase savings due to limited access to credit
  • Myopia (short-sightedness) of households may prevent fully anticipating future tax increases and adjusting savings accordingly
  • Intergenerational altruism households may not care about tax burden on future generations, weakening Ricardian equivalence effect
  • Uncertainty about future tax policies makes it difficult for households to adjust savings
• Limitations of Ricardian equivalence theory
  • Assumes rational, forward-looking households
  • Ignores potential positive effects of government spending on economic growth and productivity (infrastructure investments, education)