Answer to Question #289892 in Macroeconomics for REE

Question

Explain the macroeconomic effects of a tax cut according to the Ricardian Equivalence proposition. Include in your answer the IS-LM graph that shows the effects of this tax cut.

Answer 1

Considering Treasury bills and bonds are seen as loans that must be repaid at some point, it is reasonable to assume that they will boost taxes in the near future. This raises the question of whether to pay taxes now or later.

It is anticipated that if the government finances some of its operations with deficits, there will be deferred tax that will be paid later. According to the Ricardian equivalence proposition, the government saves in expectation of future tax increases in order to meet its tax payment obligations in the future, resulting in a reduction in present consumption. The future aggregate demand effect is the same as if the government started taxing right now.

Generally, increased consumption leads to an increase in money demand and interest rates, which reduces investment and income.