Question

A lump-sum increase in current taxes would cause interest rates to

	a) fall if Ricardian equivalence held.
	b) fall if Ricardian equivalence did not hold.
	c) fall regardless of whether Ricardian equivalence held.
	d) rise.

Answer 1

a. A lump-sum increase in current taxes would cause interest rates to fall if Ricardian equivalence hold good. This statement is true because ricardian equivalence refers to is a theory which states it’s a big failure to stimulate an economy by increasing debt-financing government spending. This theory argues that the people will save more in order to pay future taxes.

The country where government debt is higher, the saving of household is also higher.

b. A lump-sum increase in current taxes would cause interest rates to fall if Ricardian equivalence did not hold good. This statement is false. Because this theory has an unrealistic assumption that if the taxes rises, the households will starts saving more. This will leads to fall in interest rate to increase borrowing by the government. So this theory needs to hold true for such situation.

c. False. Ricardian equivalent assumes that people will save as to pay taxes in future. Also, another assumption is that they will not use windfall and income of people will remain same. Therefore, the taxes will fall but only if this theory is valid.

d. This is false because the increase in taxes do not lead to rise in interest rates.