Economics • Economic BasicsHard
In the context of fiscal policy, what does the 'Ricardian Equivalence Theorem' suggest about government borrowing versus taxation?
A. Taxation and government borrowing have identical expansionary effects on aggregate demand.
B. Financing government expenditure through debt rather than taxation has no effect on real consumption or aggregate demand because rational consumers increase savings to pay anticipated future taxes.✓ Correct Answer
C. Budget deficits always lead to hyperinflation in the long run.
D. Cutting taxes stimulates lifetime permanent income, causing a permanent upward shift in consumption.
💡 Solution & Explanation
The Ricardian Equivalence Theorem suggests that government spending financed through debt rather than taxation has no net impact on aggregate demand because rational consumers foresee future tax increases to service the debt and increase their private savings correspondingly. Consequently, fiscal expansion via borrowing fails to stimulate output in theory.
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