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When the government increases spending by borrowing today, which will be repaid by taxes in the future, it will have the same impact on the economy as an increase in government expenditure that is financed by a tax increase today.
Which of the following theories is best described by the above passage?
- a)Rational Choice Theory
- b)Ricardian equivalence
- c)Laissez Faire Capitalism
- d)Theory of Optimal Taxation
Correct answer is option 'B'. Can you explain this answer?
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When the government increases spending by borrowing today, which will...
- Traditionally, when a government cuts taxes and runs a budget deficit, consumers respond to their aftertax income by spending more. A counter argument is that consumers are forward-looking and will base their spending not only on their current income but also on their expected future income.
- They will understand that borrowing by the government today means higher taxes in the future. Further, the consumer will be concerned about future generations because they are the children and grandchildren of the present generation and the family which is the relevant decision making unit, continues living. They would increase savings now, which will fully offset the increased government dissaving so that national savings do notchange. This view is called Ricardian equivalence after one of the greatest nineteenth century economists, David Ricardo, who first argued that in the face of high deficits, people save more.
- It is called ‘equivalence’ because it argues that taxation and borrowing are equivalent means of financing expenditure. When the government increases spending by borrowing today, which will be repaid by taxes in the future, it will have the same impact on the economy as an increase in government expenditure that is financed by a tax increase today.
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When the government increases spending by borrowing today, which will...
Ricardian Equivalence
Ricardian equivalence is an economic theory that suggests that the method of financing government expenditure does not have an impact on the overall economy. According to this theory, the government's decision to borrow money or raise taxes to finance its spending does not affect the aggregate demand or overall economic activity.
Explanation:
When the government increases spending by borrowing today, it essentially means that it is financing its expenditure by taking loans from the market. The borrowed money will have to be repaid in the future, and this repayment will be funded by taxes levied on the public.
On the other hand, if the government increases expenditure by raising taxes today, it is directly collecting revenue from the public to finance its spending.
According to the Ricardian equivalence theory, individuals are forward-looking and rational. They understand that the government's borrowing today will result in higher taxes in the future to repay the debt. As a result, they anticipate the future tax burden and adjust their behavior accordingly.
Key Points:
- Ricardian equivalence theory states that individuals understand that government borrowing today will result in future tax increases.
- Individuals adjust their behavior in anticipation of future tax burdens.
- The theory suggests that the method of financing government expenditure (borrowing or taxation) does not impact the overall economy.
- An increase in government spending financed by borrowing today is considered equivalent to an increase in government spending financed by tax increases today.
Conclusion:
In conclusion, the passage best describes the theory of Ricardian equivalence. It suggests that the method of financing government expenditure, whether through borrowing or taxation, does not have an impact on the overall economy. This theory is based on the assumption that individuals are forward-looking and understand the implications of government borrowing and taxation on future tax burdens.
Ricardian equivalence is an economic theory that suggests that the method of financing government expenditure does not have an impact on the overall economy. According to this theory, the government's decision to borrow money or raise taxes to finance its spending does not affect the aggregate demand or overall economic activity.
Explanation:
When the government increases spending by borrowing today, it essentially means that it is financing its expenditure by taking loans from the market. The borrowed money will have to be repaid in the future, and this repayment will be funded by taxes levied on the public.
On the other hand, if the government increases expenditure by raising taxes today, it is directly collecting revenue from the public to finance its spending.
According to the Ricardian equivalence theory, individuals are forward-looking and rational. They understand that the government's borrowing today will result in higher taxes in the future to repay the debt. As a result, they anticipate the future tax burden and adjust their behavior accordingly.
Key Points:
- Ricardian equivalence theory states that individuals understand that government borrowing today will result in future tax increases.
- Individuals adjust their behavior in anticipation of future tax burdens.
- The theory suggests that the method of financing government expenditure (borrowing or taxation) does not impact the overall economy.
- An increase in government spending financed by borrowing today is considered equivalent to an increase in government spending financed by tax increases today.
Conclusion:
In conclusion, the passage best describes the theory of Ricardian equivalence. It suggests that the method of financing government expenditure, whether through borrowing or taxation, does not have an impact on the overall economy. This theory is based on the assumption that individuals are forward-looking and understand the implications of government borrowing and taxation on future tax burdens.
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When the government increases spending by borrowing today, which will be repaid by taxes in the future, it will have the same impact on the economy as an increase in government expenditure that is financed by a tax increase today.Which of the following theories is best described by the above passage?a)Rational Choice Theoryb)Ricardian equivalencec)Laissez Faire Capitalismd)Theory of Optimal TaxationCorrect answer is option 'B'. Can you explain this answer?
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