Question

Which is the best characterization of the theory of Ricardian equivalence?

1) A theory that suggests that changes in government borrowing have no effect on aggregate demand
2) A theory that suggests that changes in government borrowing have a positive effect on aggregate demand
3) A theory that suggests that changes in government borrowing have a negative effect on aggregate demand
4) A theory that suggests that changes in government borrowing have an uncertain effect on aggregate demand

Answer 1

Ricardian equivalence suggests changes in government borrowing are neutralized by changes in private saving, thus having no effect on aggregate demand.

Step-by-step explanation:

The theory of Ricardian equivalence suggests that changes in government borrowing or saving are offset by opposite changes in private saving. The options presented ask for the characterization of this theory's impact on aggregate demand.

The correct answer is 1) A theory that suggests that changes in government borrowing have no effect on aggregate demand. Ricardian equivalence posits that an increase in government borrowing will lead to an increase in private saving as rational private households plan for future tax liabilities.

Conversely, when government borrowing decreases, private saving is reduced.

Therefore, if the theory holds true, changes in government borrowing have no significant impact on private investment in physical capital or the trade balance, as any change in budget deficits or surpluses would be offset by a corresponding change in private saving.