Answer to Question #289894 in Macroeconomics for REE

Question

Suppose the Ricardian Equivalence proposition holds. What does this imply about the ability of fiscal policy to affect GDP? Explain.

Answer 1

Tax cuts, for example, are described by the Ricardian Equivalence thesis. According to the Ricardian Equivalence argument, a tax cut will not affect the demand for goods. A tax decrease will raise the budget deficit in the current fiscal year. To pay off this debt, taxes will have to rise at some point in the future, say one year. They'll see that the current-period tax cut is equivalent to a future-period tax rise with the identical present value. As a result, they discover that the tax cut does not affect their wealth. As a result, they do not raise consumption. They save the entire tax reduction.

According to the IS-LM model, the tax cut does not affect demand or consumption. As a result, there is no change in production or interest rate, and the IS curve remains unchanged. In other words, the tax cut will have little impact on household spending. So all we'd see is an increase in private savings, no change in consumption, demand, or output.