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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. Effectively, taxation and borrowing are equivalent means of financing the expenditure of the government.
Which of the following is best described in the passage given above?
- a)Paradox of thrift
- b)Kuznets' inverted-U hypothesis
- c)Solow growth model
- d)Ricardian equivalence
Correct answer is option 'D'. Can you explain this answer?
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When the government increases spending by borrowing today, which will...
- Option (d) is the correct answer: Ricardian equivalence was a theory put forward by David Ricardo in the early 19th century and later was elaborated upon by Harvard professor Robert Barro. For this reason, Ricardian equivalence is also known as the Barro-Ricardo equivalence proposition.
- It is an economic theory that argues that attempts to stimulate an economy by increasing debt- financed government spending are doomed to fail because the demand remains unchanged.
- This is because consumers anticipate the future so if they receive a tax cut financed by government borrowing they anticipate future taxes will rise. Therefore, their lifetime income remains unchanged and so consumer spending remains unchanged.
- 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.
- The paradox of thrift: It is an economic theory which stipulates that personal savings are a net drag on the economy during a recession. It assumes that an increase in autonomous saving leads to a decrease in aggregate demand and thus a decrease in gross output which will, in turn, lower total saving.
- The Solow Growth Model is an exogenous model of economic growth that analyzes changes in the level of output in an economy over time as a result of changes in the population growth rate, the savings rate, and the rate of technological progress.
- Kuznets' inverted-U hypothesis implies that economic growth worsens income inequality first and improves it later at a higher stage of economic development.
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When the government increases spending by borrowing today, which will...
Ricardian equivalence is the best described concept in the given passage. Ricardian equivalence is an economic theory that suggests that when the government increases spending by borrowing, 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. This means that the method of financing government expenditure, whether through borrowing or taxation, does not have a significant impact on the overall economy.
Explanation:
1. Ricardian equivalence:
- It is an economic theory named after the economist David Ricardo.
- According to this theory, individuals are forward-looking and rational in their economic decisions.
- Individuals anticipate that government borrowing today will lead to higher taxes in the future to repay the debt.
- As a result, they increase their savings or reduce consumption today to prepare for the future tax burden.
- In other words, individuals effectively save the amount of the government borrowing in anticipation of future taxes.
- This implies that an increase in government expenditure today, whether financed by borrowing or taxation, has the same impact on the economy.
- The theory suggests that individuals perceive taxes and borrowing as equivalent means of financing government expenditure.
2. Increase in government spending by borrowing:
- When the government increases spending by borrowing, it injects money into the economy through increased expenditure.
- This can have positive effects on economic growth and job creation in the short term.
- However, this borrowing will need to be repaid in the future through higher taxes.
- Individuals anticipate these future tax increases and adjust their behavior accordingly.
3. Increase in government spending financed by tax increase:
- Alternatively, if the government increases spending by raising taxes, it reduces individuals' disposable income.
- This can have a negative impact on consumption and economic growth in the short term.
- However, individuals perceive this tax increase as necessary to finance government expenditure.
- They adjust their behavior by reducing savings or increasing consumption to maintain their desired level of utility.
4. Equivalent impact on the economy:
- Ricardian equivalence suggests that regardless of the method used to finance government expenditure, the impact on the economy is the same.
- Individuals save or adjust their behavior in response to future tax increases.
- As a result, the increase in government expenditure today, whether financed by borrowing or taxation, does not significantly impact aggregate demand or economic growth.
In conclusion, the passage describes the concept of Ricardian equivalence, which states that borrowing and taxation are equivalent means of financing government expenditure. Individuals adjust their behavior in anticipation of future tax increases, resulting in a similar impact on the economy regardless of the method of financing.
Explanation:
1. Ricardian equivalence:
- It is an economic theory named after the economist David Ricardo.
- According to this theory, individuals are forward-looking and rational in their economic decisions.
- Individuals anticipate that government borrowing today will lead to higher taxes in the future to repay the debt.
- As a result, they increase their savings or reduce consumption today to prepare for the future tax burden.
- In other words, individuals effectively save the amount of the government borrowing in anticipation of future taxes.
- This implies that an increase in government expenditure today, whether financed by borrowing or taxation, has the same impact on the economy.
- The theory suggests that individuals perceive taxes and borrowing as equivalent means of financing government expenditure.
2. Increase in government spending by borrowing:
- When the government increases spending by borrowing, it injects money into the economy through increased expenditure.
- This can have positive effects on economic growth and job creation in the short term.
- However, this borrowing will need to be repaid in the future through higher taxes.
- Individuals anticipate these future tax increases and adjust their behavior accordingly.
3. Increase in government spending financed by tax increase:
- Alternatively, if the government increases spending by raising taxes, it reduces individuals' disposable income.
- This can have a negative impact on consumption and economic growth in the short term.
- However, individuals perceive this tax increase as necessary to finance government expenditure.
- They adjust their behavior by reducing savings or increasing consumption to maintain their desired level of utility.
4. Equivalent impact on the economy:
- Ricardian equivalence suggests that regardless of the method used to finance government expenditure, the impact on the economy is the same.
- Individuals save or adjust their behavior in response to future tax increases.
- As a result, the increase in government expenditure today, whether financed by borrowing or taxation, does not significantly impact aggregate demand or economic growth.
In conclusion, the passage describes the concept of Ricardian equivalence, which states that borrowing and taxation are equivalent means of financing government expenditure. Individuals adjust their behavior in anticipation of future tax increases, resulting in a similar impact on the economy regardless of the method of financing.
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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. Effectively, taxation and borrowing are equivalent means of financing the expenditure of the government.Which of the following is best described in the passage given above?a)Paradox of thriftb)Kuznets' inverted-U hypothesisc)Solow growth modeld)Ricardian equivalenceCorrect answer is option 'D'. Can you explain this answer?
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