Question

Think about a small open economy. Its government announces that they will have a tax cut of $200 million this year, and there will be a tax increase of $210 million next year, when the interest rate is 5%.

Question: If Ricardian equivalence does not hold, what are the effects of this change (tax cut and subsequent tax increase) on

a. the world real interest rate,

b. national saving, investment, and

c. the current account balance in equilibrium?

Answer 1

1. When they have a tax cut of $200 million then the world real interest rate will increase as the level of income flow will be high and the tax increase will lead to decline in the world real interest rate as flow of income will be low and thus consumer spending will also be low.
2. When the economy is having a tax cut then it may lead to increasing the level of the national saving and the investment and on the other hand the tax increase may reduce the level of the national saving and the investment.
3. When there is having the tax cut in the economy then it will lead to deficit in the current account balance due to increase in the level of consumer spending on imports and on the other hand the increase in taxes will lead to decline in the deficit in current account balance