Final answer:
The Ricardian equivalence theorem proposes that individuals anticipate future taxes due to government deficits and increase savings, nullifying the effect on output. These actions hypothetically offset government borrowing, according to the national saving and investment identity, though empirical evidence only partially supports this.
Step-by-step explanation:
The student's question refers to the option D which is the correct one regarding the Ricardian equivalence theorem: people recognize that current deficits must be paid in the future and therefore increase savings today to pay higher future taxes.
Ricardian equivalence is a theory in economics which suggests that when a government incurs a budget deficit, rational private households will anticipate the need for the government to increase taxes in the future to pay off the debt. Therefore, these households will increase their savings now to prepare for the future tax burden, which would offset the government’s deficit spending, with no effect on the overall level of output. The key concept here is that households behave in a way that neutralizes the fiscal policy by altering their saving behavior.
However, empirical evidence does not consistently support Ricardian equivalence; it is observed to hold true only partially. A change in government borrowing prompts changes in either private savings, investment in physical capital, or the trade balance, or some combination of the three, according to the national saving and investment identity.