Rational Expectations with Liquidity Constraints Optimizing Framework for Ricardian Equivalence Testing In Indonesia

Ricardian Equivalence hypothesis suggests that government spending financed by current taxes or future taxes (deficit) will have an equal impact on the economy. The objective of this study is to analyze validity of Ricardian equivalence in rational expectation optimizing framework which incorporates liquidity constraints hypotheses in Indonesia. Aschauer (1985) develops a Rational Expectation Optimizing (REO) model to analyze validity of Ricardian equivalence. However, the fragility of REO model results from the omission of disposable income variable in the model. This study incorporates disposable income variable into REO model and allows existence of liquidity-constrained consumers. The contribution of this study is to provide better model to investigate validity of Ricardian equivalence in rational expectation optimizing framework with liquidity constraints so-called Rational Expectation with Liquidity Constraints Optimizing (RELCO) model in Indonesia. This study conducts quantitative analysis methodology, utilizing Full Information Maximum Likelihood (FIML) to examine rational expectation-Ricardian with RELCO and REO models using Indonesia time series data period 1969-2022. The findings reveal that rational expectation-Ricardian hypothesis is rejected, proves existence of liquidity-constrained consumers in Indonesia, demonstrate impact of government expenditure and consumption varies, and RELCO model is better than the REO model. This study affirms that Indonesian consumers do not perceive government spending financed by taxes as equivalent to deficit/debt. Furthermore, it acknowledges the existence of budget-constrained consumers in Indonesia. However, the influence of government spending on consumption remains inconclusive. Finally, this study highlights that incorporating income variables into the model improves regression outcomes.