CFA Level I · CFA Level I Exam · Fiscal Policy
An economist states that if households fully anticipate that a deficit-financed tax cut today will require higher taxes in the future, they will save the entire tax cut and aggregate demand will be unchanged. This proposition is best described as:
The proposition is Ricardian equivalence. Forward-looking households expect a deficit-financed tax cut to be repaid through higher future taxes, so they save the whole tax cut, leaving consumption and aggregate demand unchanged. Crowding out and the balanced budget multiplier describe different mechanisms.
- Athe crowding-out effect.
- BRicardian equivalence.Correct
- Cthe balanced budget multiplier.
Explanation
Ricardian equivalence holds that rational, forward-looking households offset deficit-financed tax cuts by saving more, because they expect higher future taxes with the same present value. Crowding out concerns higher interest rates reducing private investment. The balanced budget multiplier concerns equal changes in spending and taxes.
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