Question

Ricardian equivalent theorem does not apply to credit-constrained consumers because the optimal consumption bundle, the timing of tax:

a. is independent from
b. may change with credit constraints.

Answer 1

The Ricardian equivalent theorem, which implies that government borrowing doesn't affect overall levels of saving, investment, or trade balances, does not apply to credit-constrained consumers who cannot adjust savings to anticipate future taxes.

Step-by-step explanation:

The Ricardian equivalent theorem posits that under certain conditions, changes in government borrowing do not affect overall levels of saving, investment, or trade balances because rational private households adjust their saving to offset government borrowing. However, the theorem does not apply to credit-constrained consumers because their ability to adjust savings in anticipation of future taxes is limited. Therefore, the timing of tax changes may change with credit constraints, as these consumers cannot easily shift consumption across time to smooth out the effects of taxation. In contrast, without credit constraints, the timing of tax changes would be independent of consumer behavior, embodying the Ricardian equivalence.