Question

1. According to the Ricardian equivalence theorem, an increase in government spending (G) would:

Increase aggregate demand as consumer spending would not change

Decrease aggregate demand as consumer spending would decrease more than the increase in G

Not change aggregate demand as consumer spending would decrease by the opposite amount as the increase in G

Not change aggregate demand as household savings would decrease

2.  From a functional finance perspective, when the economy is in an inflationary gap the government should:

do nothing

run a deficit

run a surplus

run a balanced budget

Answer 1

Question 1

Option C is correct - Not change aggregate demand as consumer spending would decrease by the opposite amount as the increase in G

The Ricardian Equivalence theorem states that the government's attempt to stimulate the economy by increasing its spending does not lead to an increase in aggregate demand. Instead, the consumers anticipate that the future tax rates will be higher and in order to pay those taxes they start saving more and the consumer spending decreases.

Thus, in this case, aggregate demand does not change at all and the consumer savings increase in order to pay high taxes in the future.

Question 2

Option C is correct- Run a surplus

Functional finance is a concept which states that economic fluctuations can be eliminated through government intervention. The government can intervene in the form of raising or lowering taxes, spendings and borrowings, and printing money.

During an inflationary gap in the economy, real GDP> potential GDP. In this situation, demand exceeds the production of goods and services and people have too much money in their hands. Thus running a surplus budget would mean, government collecting more than it is spending. The government can collect more in the form of higher taxes and lower their spendings so that excess money in the hands of people gets reduced and so does the demand. And the economy will be back to normal.