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Generate QuizAccording to the 'Ricardian Equivalence' theorem, if the government finances a massive infrastructure project by issuing bonds (borrowing) rather than raising taxes today, what will rational consumers do?
- Spend the extra disposable income immediately, boosting aggregate demand
- Increase their private savings to pay for the anticipated future taxes required to repay the government debt
- Invest heavily in the stock market due to increased government spending
- Demand higher wages to compensate for the expected inflation
Answer: Increase their private savings to pay for the anticipated future taxes required to repay the government debt
David Ricardo theorized that forward-looking, rational consumers understand that government borrowing today must be repaid with interest via higher taxes tomorrow. Therefore, they will not treat a debt-financed tax cut as an increase in their permanent wealth. Instead, they will save the extra income to pay those future taxes, completely neutralizing the government's attempt to stimulate aggregate demand through deficit spending.