Ricardo Redux
Subject The Ricardo Effect
Topic Inflation
Key Words Inflation, Saving, Interest Rates, Federal Reserve
News Story

Economists have attributed a significant role to the increase in consumer spending resulting from the "wealth effect." According to the wealth effect, increases and decreases in wealth produce increases or decreases in consumer spending and opposite changes in savings. There is another explanation for recent increases in consumer spending and spending that leads to a different prediction for future spending and savings behavior. The genesis of that alternate explanation is David Ricardo. According to the Ricardo effect, consumers' savings behavior is determined in part by government borrowing. The much-heralded government surplus could fuel increased spending rather than forecasted decreases.

Ricardo argued that individuals understood that rising federal debt represented an increased future tax obligation. Accordingly, individuals would adjust their consumption/savings to include this obligation. Falling federal deficits produce increased consumption and reduced savings, according to Ricardo and his followers. If, as some economists believe, the Ricardo effect is an important determinant of savings/consumption behavior, reductions in the federal debt would have produced reduced savings and forecasted government surpluses would continue to exert a positive influence on consumption.

There is some evidence to support this theory. Declines in savings began before the recent run-up in stock market. The stock market started its rapid growth in 1995 but the savings rate started to decrease in 1992. Savings decreased in a number of European and other countries in the early 1990s, when government deficits were falling but stock prices had not risen. France, on the other hand, has experienced a recent wealth increase, but an increased savings rate that Ricardo advocates attribute to the increase in France's structural deficit.

While the importance of the Ricardo effect is controversial, the implications for monetary and fiscal policy are significant. The Federal Reserve has kept a close eye on stock prices and used rapid runups in prices as justification for interest rate hikes. To the extent that the Ricardo effect is important, the Fed should have been watching changes in the deficit. Both Presidential candidates have proposed tax cuts in the coming year. Tax cuts, according to Ricardo, would result in reduced consumption and may produce reduced surpluses.

(Updated November 1, 2000)


What is the "wealth effect?" How would an increase in stock prices affect consumer spending? Consumer saving?

2. What is the "Ricardo effect?" According to Ricardo, how would an increase in stock prices affect consumer spending? How would a decrease in the Federal government deficit affect consumer saving?
3. According to Ricardo, what is the impact of a proposed tax cut on consumer spending?
Source Gene Koretz, "Are Surpluses Hurting Savings;" Business Week, October 2, 2000.

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