Question

Q .2.0 Again, think about the extreme case of crowding out known as “Ricardian equivalence.” In real life, few citizens buy or sell government bonds directly: Instead, normal people put their money in a bank (or invest it in a mutual fund), and then their bank (or mutual fund) uses that money to buy government bonds.

a. So does a tax cut mean banks will get more deposits, fewer deposits, or can’t you tell with the information given? (5 points)

Answer 1

According to Ricardian equivalence,people anticipate that the public expenditure or tax cut financed by government borrowing will lead to a future rise in tax. So the people will save the tax cut for future tax payment. So the expansionary fiscal policy doesnot increase the aggregate demand because the people will use the increased taxcut to pay the future tax increases.

In crowding out effect it's says that the expansionary fiscal policy doesn't meet the desired income due to rise in rate of interest. We know that there exist a direct relationship between rate of interest and saving. So when rate of interest increases savings also increases,i.e,deposits increases.

In Ricardian equivalence ,the taxcut cause no impact on life time income. People will save the increased taxcut for future tax increase. So there will be a increase in deposit.

So we can say that this taxcut will increase the tendency of people to save money and also there will be increase in rate of interest which attract the people to save more. This helps in increases deposit to banks. However this tax cut is only for short period.

So we can say that a taxcut will increase the bank deposit for a short period (because tax cut are for short period and people know that there will be tax increase soon. So they save the taxcut money till the tax rate increases)