Chapter 36, Problem 7MCQ

To determine

The correct option for the argument of Ricardian equivalence when households and firms see government spending increase.

Answer to Problem 7MCQ

From the available options, the correct option is tax rates will decrease as a result

Explanation of Solution

As the Ricardian equivalence theory states that customers won't alter their current expenditure when they expect a future tax hike which means if households, customers or firms would see that the government will increase its spending in future then they assume that the tax rates would decrease. However, if there is increase in government expenditure then federal deficit would not decline and there is zero impact of government spending on interest rates.

Moreover, if government increases its expenses, then it may decrease the spending of private sector.

Therefore, the correct option is d (tax rates will decrease as a result) and all other options are incorrect because people will expect low tax rates in future when government plans to increase its expenditure.

Economics Concept Introduction

Introduction: According to the economic theory of Ricardian equivalence, paying government spending with current taxes or future taxes will have similar impacts on the nation's economy as a whole.