Failure of the Ricardian Equivalence Theory in Economies with Incomplete Markets

Abstract

We investigate whether or not the Ricardian Equivalence Theorem (RET) holds in a naive economy with incomplete financial markets. Even in this artificially favorable environment, where public debt has a perfect substitute, the RET fails if we allow the payoff matrix to vary. For the RET to hold, we need to assume that the risk-free payoff belongs to the asset span of the economy and the law of one price is valid. Given that these are strong assumptions, we show that the failure of the RET is robust, in the sense that there exists an open set of payoff matrices such that the RET fails.