economics hard MCQ

The 'Ricardian Equivalence' theorem suggests that:

  1. Government spending is always more effective than tax cuts in stimulating the economy
  2. Consumers are forward-looking and will increase their savings to pay for future taxes if the government finances current spending through debt instead of taxes
  3. Deficit spending inevitably leads to hyperinflation in developing nations
  4. Monetary policy is completely ineffective during a liquidity trap

Answer: Consumers are forward-looking and will increase their savings to pay for future taxes if the government finances current spending through debt instead of taxes

Proposed by David Ricardo, this theory argues that the method of financing government spending (taxes vs. debt) is irrelevant to aggregate demand. Rational consumers know that government borrowing today must be repaid with interest via higher taxes tomorrow. Therefore, they will save the extra income from a tax cut or debt issuance to pay those future taxes, neutralizing any fiscal stimulus.

Topic Macroeconomics - Fiscal Policy
Exam Relevance UPSC Prelims, SSC CGL
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