Ricardian equivalence is most likely to fail when households face which condition?

• A. Perfect capital markets and forward-looking behavior
• B. Liquidity constraints
• C. No expected taxes
• D. High impatience

Answer: (B)

Ricardian equivalence relies on households being able to smooth consumption over time by saving in response to government borrowing. If the debt-financed tax cut makes people expect higher future taxes, they save more today, so current consumption stays the same and national saving isn’t affected.

But when households face liquidity constraints, that smoothing isn’t possible. They can’t borrow against future income or save enough to offset the tax cut’s effect, so they use the extra current income to spend now. The debt-financed fiscal expansion then raises current consumption and lowers current saving, breaking the offset that Ricardian equivalence relies on.