Ricardian equivalence states that a deficit-financed increase in government spending will not lead to an increase in aggregate demand. If consumers are 'Ricardian' they will save more now to compensate for the higher taxes they expect to face in the future, as the government has to pay back its debts. The increased government spending is exactly offset by decreased consumption on the part of the public, so aggregate demand does not change.
As noted here, John Cochrane made the same error. I would hope the Myron S. Scholes Professor of Finance at the University of Chicago Booth School of Business does not rely upon Wikipedia for his economic research. Alas, in an otherwise excellent post on fiscal policy, Menzie Chinn sort of falls into this trap as well:
Case 5 (government debts will have to be paid off in its entirety the future): When budget constraints hold with certainty intertemporally, and there is no way to default even partially on government debt (say via unexpected inflation), then increases in government debt due to tax cuts (for instance) induce no change in current consumption because households fully internalize the present value of the future tax liability
Menzie is right about transitional changes in tax policy not being able to change consumption in this Barro-Ricardo model, which is why GOP calls for using tax cuts to stimulate demand are likely not going to be the most effective policy tool. But what about transitional changes in government purchases? It is interesting that Wikipedia noted Ricardo’s 1820 Essay on the Funding System:
Ricardo studied whether it makes a difference to finance a war with the £20 million in current taxes or to issue government bonds with infinite maturity and annual interest payment of £1 million in all following years financed by future taxes. At the assumed interest rate of 5%, Ricardo concluded that "In point of economy there is no real difference in either of the modes, for 20 millions in one payment, 1 million per annum for ever ... are precisely of the same value".
Let’s modernize this example. Suppose we decide to have an additional $100 billion in public investment in 2009. In Ricardo’s example, permanent taxes will increase by $5 billion per year which would have a very modest offsetting reduction in consumption. So if government purchases rise by $100 billion and consumption falls by $5 billion, then isn’t the direct impact on aggregate demand closer to $95 billion for the year rather than zero?
Update: Republicans will oppose more government spending as they prefer tax cuts:
Hours before a meeting with President Barack Obama, House Republican leaders sought to rally opposition Tuesday to a White House-backed economic stimulus measure with an $825 billion price tag. Several officials said that Reps. John Boehner of Ohio, the GOP leader, and Eric Cantor of Virginia, his second-in-command, delivered the appeal at a closed-door meeting of the Republican rank and file. Both men said the legislation contains too much wasteful spending that will not help the economy recover from its worst nosedive since the Great Depression, the officials added ... Senate Republican Leader Mitch McConnell, R-Ky., said in a televised interview that Obama was having problems with Democrats, whom he said favor spending over tax cuts as a remedy for the economic crisis.
If Ricardian Equivalence holds, the GOP is opposing fiscal stimulus that will impact aggregate demand preferring tax cuts that will not increase aggregate demand. Go figure!