Ricardo's theory

Ricardian equivalence, named after economist David Ricardo, proposes that with regards to private spending, it does not matter when in time a government finances a given fixed spending programme. This means, for example, that a government cuts taxes by £1bn in this year, and pays for its pre-planned spending scheme through borrowing. This borrowing is made through selling bonds to the private sector.

The value of the bonds sold is equal to that of the tax cut: £1bn. This represents the present value of future income to the bondholders, and must have interest paid on it by the government - which will be financed by higher taxes in the future. The private sector gets a benefit this year which will be offset by a penalty of higher taxes of identical present value. In this way, the private sector is neither richer nor poorer, and so its desired spending should not change - so it is irrelevant when a government finances its spending.

Problems with Ricardian equivalence

Ricardo himself argued that his hypothesis was not appropriate to the real world! Debate still exists, over 200 years later, as to the degree to which the theory should hold. The main problem is that tax cuts do in fact stimulate demand to an extent, even if future taxes will be correspondingly higher. Firstly, people will spend more immediately when heavier taxes are in the distant future. Businesses may be more cautious, but household consumption naturally rises when disposable income is larger. To complement this, reducing tax rates can increase the potential output of the whole economy, which raises income. Not only do people have less of their income going to taxes, but more income in the first place. Again, this stimulates more spending.

Secondly, governments can borrow at very low interest rates due to their inability to go bankrupt. Households and firms are riskier so lenders charge higher interest. This means that the present value of the future taxes is less then £1bn because of the higher interest rate. The tax cut is a fiscal expansion as the government borrows on good terms, then lends to the private sector at better terms than the capital market: the private sector is therefore better off and aggregate demand increases.

These factors showing that the timing of government spending does affect the private sector demonstrate that Ricardian equivalence is too strong to hold in the real world. Tax cuts increase aggregate demand, even if it is reduced in the future by a tax increase. However, firms and households are not fully stupid, and the expectation of a tax increase does affect current behaviour: when public saving falls, private saving rises and vice versa.

To hold money - cash - involves a cost: holding money in your wallet means it is not in the form of an interest bearing asset such as a bond or equity. There are several issues considered when deciding how wealth is divided between assets and cash: how useful cash is for transactions, cash as a financial precaution, and the benefits asset holding will bring. These issues are also analysed by the economist when examining the aggregate demand for different forms of money.

So what are the benefits of holding cash?

Assets make money earn extra through interest, so in theory are the most beneficial way to hold money. However, particularly where small sums are involved, they are not convenient. It is awkward, for example, to write a cheque for a bus fare, or to know the exact time at which to buy and sell assets when cash is required. The latter also involves brokerage fees which can often outweigh the value of interest earned. What this entails is that all transactions are not synchronised: were it possible to make all transactions in the same moment, there would be no need for cash apart from at that point. In this way, it is necessary to have cash as a store of money to make transactions as and when required. The value of cash held depends on the value of transactions required.

As transactions are not synchronised, and planning all transactions is difficult, it is necessary to hold cash surplus to that which is budgeted in order to meet unforseen contingencies. The demand for money in this case rests on the proportion of transactions which are undertaken with a larger than average degree of uncertainty: if many unplanned purchases are made, the benefit from holding spare cash is greater as it covers these transactions. A shopper with a propensity for spontaeneous purchases, for example, would have a higher demand for cash, as the benefit from holding that cash is more regularly reaped.

What about making money work?

Holding some wealth as assets is naturally the alternative to hoarding suitcases of cash under the bed. The question of assets rests more on how a portfolio is divided between risky and safe assets. The so-called 'asset motive' reflects a dislike of risk: the chances of losing so much wealth in a risky asset are higher due to the nature of such an asset, therefore the possible higher returns of this asset are sacrificed for an investment with a smaller but safer return.

So how decide?

The division between holding cash and assets rests upon the degree to which the benefit of holding another pound, dollar, yen or franc exceeds the cost of holding it. The marginal cost of holding money is constant as long as interest rate remains so, as the cost is the interest forgone by not holding bonds. The marginal benefit declines as money holdings increase, so with a low level of money holding, the benefit of that extra pound is high. With lots of money in hand, one more pound does not make an awful lot of difference, as there is already plenty accessible for transactions. The optimal level of money holding, therefore, is where the benefit of holding the extra unit cash is exceeded by the cost of not holding it as an interest bearing asset. In economics, this is usually represented as a graph, with a horizontal line representing marginal cost and an inverse line representing marginal benefit, with the optimal level being the point at which the lines intersect. The demand for money therefore rests on the cost of holding cash which doesn't bear interest, and the benefit of holding money for transactions.

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