Question

Consider three countries. The first country runs small budget surpluses each year. The other two countries run large budget deficits each year. In one of the deficit countries, the national debt-to-GDP ratio has been steady, whereas in the other deficit country, the national debt-to-GDP ratio has been rising. Suppose each of these countries decides to reduce income taxes. Is Ricardian equivalence likely to hold in all of these countries?

Ricardian equivalence is most likely to hold in:

a. The country with the rising debt-to-GDP ratio—people in this country are most likely to fear the tax cut will be unsustainable and therefore temporary.

b. All countries because reducing taxes will stimulate aggregate demand.

c. The country with the budget surplus—people in this country will spend the entire amount of the tax reduction because they view it as a windfall.

d. The countries with the budget deficits—these countries are most likely to be in a recession, so the tax reduction will compensate for reduced income levels due to the recession.

Answer 1

Answer:

Ricardian equivalence is economic hypothesis holding that consumers are forward looking and internalize government budget constraint this leads to no affect on consumption decision and thus does not change aggregate demand (AD).

From the above example first country does not hold the Ricardian equivalence as under this theory countries who are run under deficit and government decreases the income tax rate to correct it are only included in it. Condition one is not met for first country.

Ricardian Equivalence is most likely to hold in:

a) The country with rising debt........and therefore temporary.