Question

Explain the short run and long run effects of debts and deficits based on i) the standard view and ii) the Ricardian view. Explain the conditions under which the latter view holds.

Answer 1

anssss...
When the governmnt introduces deficit in the economy reducing lump sum taxes, it has severe impact on consumption, saving, investment , and interest rate both in the short run and long run.
Deficit stands for expenditure outpacing income. Normally deficit ladened budget is inflationary. The government wants to mobilise the resources from the rich to the poor for more employment and income generation.
When taxes are reduced, the purchasing power of people shall rise thereby boostig the aggregate demand in the economy. This gives rise in output and employment.
With the rise in income, the consumption level shall rise, but the quantum of rise will not be equal to the growth in income. This means some icome will go to saving. Since, the rise in income is not fully replaced by the rise in consumption, there is a gap of saving. If ths saving does not get converted into nvestment, there is less effective demand. Here, Keynes calls for mobilisation of saving into productive channels for equating the effective supply.
(a) Thus the standard view of debt and lowering of lump sum taxes is that with their rise in income, the people will save money in the hope that in future if the tax rates are raised, they should be able to cope up the situation. In the short run the people may spend more money on consumption; but in the long run they would like to maintain a balance by saving money from rise in income.
(b) Ricardian view is that when government tries to stimulate the economy by increasing debt finance goverment spending, demand remains unchanged.
(c) Permanent Life Cycle theory of Consumption
Permanent Income Hypothesis is referred to Milton Friedman which tells that in the long run the consumers would like to maximise their utility or personal well being by balancing a lifetime stream of earnings vis-vis pattern of consumption. This is very similr to Ricardian Concept of Consumption.