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a) Describe the Ricardian Equivalence. b) In an attempt to stimulate the economy, the government decides...

a) Describe the Ricardian Equivalence.

b) In an attempt to stimulate the economy, the government decides to implement a substantial tax cut. Describe in detail what would be the effects of such a policy on the economy assuming that the Ricardian Equivalence holds. Specifically describe what would happen to private consumption, saving, aggregate demand, and GDP.

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Answer #1

Ricardian equivalence states that people are forward looking and internalize government budget constraint while making economic decisions.

Tax cut will have no effect on private consumption, aggregate demand and GDP, but will have positive effect on savings, when Ricardian equivalence holds.

Consumers are forward looking and thus understand that substantial tax cut today will lead to substantial tax increase in future because governement budget has to be balanced. Thus they save more to compensate for the tax burden in future.

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