Question

Answer whether or note the following statements are true, false or uncertain. Justify your answers.

1. The Lucas critique argues that the simple Keynesian multiplier model cannot be used to evaluate the potential impact of policy because the model’s assumption of a representative agent is too simple to capture the real world.

2. Ricardian Equivalence implies that the government’s fiscal policy does not matter.

Answer 1

1.

True

As per the argument, it is true that households don’t consume simply as explained by the Keynesian economic proposals as there are different government policy variables, structural factors of the economy as well as the technological factors also affect the consumption pattern that is different to the multiplier effect as calculated by using the data of government spending or tax cut and MPC. The real world scenario faces different challenges. Inside and outside lags as well as crowding out effects are also not considered in the Keynesian proposal, but takes place in the real world. So, the argument given is correct.

2.

True

As per the Ricardian Equivalence, the increase in government spending (as a part of the fiscal policy) will be followed by a decrease in government spending. Further, the consumers also expect that decreased level of tax cut, will follow the increase in the tax in the future. It will give consumers a feeling that lifetime income will not change. As a result, the consumer spending or consumption will not increase even if the fiscal policy is in place. So, as per the Ricardian Equivalence, fiscal policy will not be effective.