Question

France's government is running a budget deficit. With no Ricardo-Barro effect, which of the following events will occur?

I.      The supply curve of loanable funds will shift leftward.

II.    A higher real interest rate crowds out investment.

III.   Saving increases.

A) I and II

B) II and III

C) I only

D) III only

Answer 1

It shall be noted that Ricardo-Barro effect is an economic theory that suggests that when a government tries to stimulate an economy by increasing debt-financed government spending, demand remains unchanged because the public increases their saving to pay for expected future tax increases that will be used to pay off the debt.

So, the government cannot stimulate consumer spending since people assume that whatever is gained now will be offset by higher taxes due in the future. It also implies that no matter how a government chooses to increase spending by borrowing or raising taxes, demand will remain unchanged, because debt-financed public spending will "crowd out" private spending.

Hence, the correct answer is a higher real interest rate crowds out investment and saving increases

Thus, the correct answer is B) II and III