Question

Define the Ricardian Equivalence Theorem. Explain the macroeconomic effects of a tax cut according to the Ricardian Equivalence proposition. Include in your answer the IS-LM graph that shows the effects of this tax cut.

Answer 1

The Ricardian Equivalence Theorem postulates that the consumers in an economy highly and positively anticipatory beings who anticipate the future government decisions based in the current government situation and thereby plan their economic activities, which ultimately leads the government to plan its budget allocation according to the plans and desires of the people. Let us take the example of the tax cut referred to as in the question. If the consumers of the economy realize that the government has announced a cut in the taxes, but that cut in the taxes has been financed by the Government borrowing from some other sources, then the consumers realize that the reduction in taxes is only temporary and in the future, there is a strong possibility that the taxes would be raised and there is likely to huge rise in the prices. This leads to the consumers not taking the full advantage or benefit of the current tax cut and saving the money for the future. The Government then is forced to alter its tax cut since there is no real affect in the economy.

  From the above IS-LM curve we can see that the Long-run income is measured in the X-axes and the Short-run income is measured in the Y-axes. As curve MN is the IS-LM curve, which determines the affect of a tax cut on the aggregate income of the consumers. Since the consumers anticipate the tax rate has been financed by the Government borrowing’s, the consumers do not change their expenditure pattern in the present, and save for the future, in the anticipation that the tax rates in the future will be considerably higher. This makes the IS LM curve to be a oval shaped curve where the income in the short run is equal to the income in the long run. IN the above diagram we can see that the point P and Q are those point’s where the cut in the taxes have straightened the IS-LM curve for a specified small amount of time, but in the longer run, the income level again comes back to the normal.