According to the Ricardian equivalence theorem, what is the effect of each of th

Question

According to the Ricardian equivalence theorem, what is the effect of each of the following on output in the economy? Explain your answers.

a. Government pays for an increase in spending by raising taxes.

Output increases because people will decrease their consumption by the same amount that spending increases. Output is not affected because people will increase their consumption by the same amount that spending increases. Output is not affected because people will decrease their consumption by the same amount that spending increases. Output decreases because people will decrease their consumption by the same amount that spending increases. Output increases because people will increase their consumption by the same amount that spending increases.

Explanation / Answer

Ricardian equivalence suggests that consumers are always forward looking and keep themselves prepared for all changes. When a government tries to stimulate an economy by increasing debt-financed government spending, demand remains unchanged. This is because the public saves its excess money to pay for expected future tax increases which it knows the government will implement to pay off the future debts.

a)

Output is not affected because people will increase their consumption by the same amount that spending increases.

b)

Output increases because people will increase their savings, offsetting the increase in the deficit.

c)

always balance the budget regardless of the state of economy

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