“Ricardian equivalence” is the claim that government deficit spending, Group of answer choices Is effectively equal to the surplus realized by all other sectors in the economy Can help moderate the business cycle Would be reduced if David Ricardo were still alive Generates expectations of future tax payments that reduce current private investment and consumption
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It is an economic theory proposed by David Ricardo, which suggests that when a government increases deficit spending, individuals anticipate future tax increases to pay off that debt. As a result, they save more in the present to prepare for those future taxes. Show more…
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Ricardian Equivalence: How does taking into account the government budget constraint affect the way we should think of the effects of deficits on output? One extreme view is that once the government budget constraint is taken into account, neither deficits nor debt have an effect on economic activity! This argument is known as the Ricardian equivalence proposition. David Ricardo, a nineteenth century English economist, was the first to articulate its logic. His argument was further developed and given prominence in the 1970s by Robert Barro. For this reason, the argument is also known as the Ricardo-Barro proposition. The best way to understand the logic of the proposition is to use an example of tax changes: Suppose that the government decreases taxes by 1 this year. And as it does so, it announces that, to repay the debt, it will increase taxes by (1+r) next year. What will be the effect of the initial tax cut on consumption? One possible answer is: No effect at all. Why? Because consumers realize that the tax cut is not much of a gift: Lower taxes this year are exactly offset, in present value, by higher taxes next year. Put another way, their human wealth—the present value of after-tax labor income—is unaffected. Current taxes go down by 1, but the present value of next year's taxes goes up by (1+r)/(1+r) = 1, and the net effect of the two changes is exactly equal to zero. Another way of coming to the same answer—this time looking at saving rather than looking at consumption—is as follows: To say that consumers do not change their consumption in response to the tax cut is the same as saying that private saving increases one-for-one with the deficit. So the Ricardian equivalence proposition says that if a government finances a given path of spending through deficits, private saving will increase one-for-one with the decrease in public saving, leaving total saving unchanged. The total amount left for investment will not be affected. Over time, the mechanics of the government budget constraint imply that government debt will increase. But this increase will not come at the expense of capital accumulation. Under the Ricardian equivalence proposition, a long sequence of deficits and the associated increase in government debt are no cause for worry. As the government is dissaving, the argument goes, people are saving more in anticipation. Explain.
Breanna O.
Explain whether or not you agree with the premise of the Ricardian equivalence theory that rational people might reason: "Well, a higher budget deficit (surplus) means that I'm just going to owe more (less) taxes in the future to pay off all that government borrowing, so I'll start saving (spending) now." Why or why not?
What is the theory of Ricardian equivalence?
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