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Why does sound finance not depend on the Ricardian equivalence theorem?

The Ricardian equivalence theorem says that people increase their savings in anticipation of an increase in taxes in the future to pay for that deficit.
Sound finance is based on political grounds, not economic principles.
The Ricardian equivalence theorem says that interest rates will rise when government increases expenditures, fully crowding out private investment.
Sound finance says that governments should make spending and taxing decisions based on their effect on the economy, not moralistic principles.

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Raushan Raj
Raushan RajLv8
28 Sep 2019

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Related questions

According to the Ricardian equivalence theorem, what is the effect of each of the following on output in the economy? Explain your answers.

a. Government pays for an increase in spending by raising taxes.

  Output increases because people will decrease their consumption by the same amount that spending increases.
  Output is not affected because people will increase their consumption by the same amount that spending increases.
  Output is not affected because people will decrease their consumption by the same amount that spending increases.
  Output decreases because people will decrease their consumption by the same amount that spending increases.
  Output increases because people will increase their consumption by the same amount that spending increases.



b. Government pays for an increase in spending by issuing bonds.

  Output is not affected because people will decrease their savings, offsetting the increase in the deficit.
  Output is not affected because people will increase their savings, offsetting the increase in the deficit.
  Output decreases because people will decrease their savings, offsetting the increase in the deficit.
  Output increases because people will increase their savings, offsetting the increase in the deficit.
  Output decreases because people will increase their savings, offsetting the increase in the deficit.
  Output increases because people will decrease their savings, offsetting the increase in the deficit.



c. The implication of your answers to a and b is that government should:

  always balance the budget regardless of the state of the economy.
  balance the budget only if the economy is in recession.
  balance the budget only if the economy is at full employment.
  balance the budget only if the economy is expanding.
 

1.Ceteris paribus, if the U.S. federal government reduces its budget deficit which of the following will be observed?

Answer

a.

The aggregate demand curve will shift to the right.

b.

The economy will always approach potential GDP.

c.

The marginal propensity to consume will increase.

d.

The average price level will increase.

e.

The aggregate demand curve will shift to the left.


2. If the government wants to close a GDP gap, it can:

Answer

a.

lower government spending on social security.

b.

adopt contractionary fiscal policies to control inflation.

c.

increase its budget deficit.

d.

repay its borrowings.

e.

raise both direct and indirect tax rates.


3. Suppose the short-run equilibrium level of income exceeds the full employment level of income and there is high inflation. Hence, the government decides to implement a fiscal policy that will act to reduce national output and price level. This can be accomplished by:

Answer

a.

lowering average tax rates such that aggregate supply is increased.

b.

increasing government spending such that aggregate expenditures are increased.

c.

increasing transfer payments such that aggregate expenditures decline.

d.

raising taxes and government spending by the same amount such that aggregate supply is decreased and aggregate demand is increased.

e.

decreasing government spending such that aggregate demand is reduced.


4. A drop in investment spending caused by increased government budget deficits is referred to as:

Answer

a.

the multiplier effect.

b.

crowding out.

c.

an expansionary gap.

d.

the paradox of thrift.

e.

the Ricardian equivalence.

5. Discretionary fiscal policy is best defined as:

Answer

a.

the deliberate manipulation of the money supply to expand the economy.

b.

the deliberate change in tax laws and government spending to change equilibrium income.

c.

the policy action taken by the Congress to reduce the federal budget deficit.

d.

the arbitrary fluctuation in tax laws and budget requirements.

e.

the automatic change in certain fiscal instruments when real GDP changes.


6. Which of the following can be considered as an automatic stabilizer in the economy?

Answer

a.

Money supply

b.

Disposable income

c.

Real exchange rate

d.

Real interest rate

e.

Unemployment insurance


7. Which of the following is true about automatic stabilizers?

Answer

a.

When income rises, automatic stabilizers increase/boost spending.

b.

Automatic stabilizers are a part of discretionary fiscal policy.

c.

An automatic stabilizer is any program that responds to fluctuations in the business cycle in a way that moderates the effects of those fluctuations.

d.

Any kind of trade policy adopted by the government will be considered as an automatic stabilizer.

e.

The interest rate is an example of an automatic stabilizer.


8. Increased budget deficits

Answer

a.

can cause interest rates to increase and hence decrease net exports

b.

have no effect on net exports

c.

can cause interest rates to decrease and hence increase net exports

d.

never impose additional interest costs on the government


9. The Ricadian Equivalence implies that when financing additional government expenditures

Answer

a.

there is no difference between increasing current taxes or borrowing now and increasing taxes in the future because consumption will decrease either way.

b.

there is no difference between increasing current taxes or borrowing now and increasing taxes in the future because consumption will increase either way.

c.

increasing borrowing is the best option

d.

increasing current taxes is the best option


10. Assuming no effects on aggregate supply, if the government increases government spending and decreases taxes in an attempt to prevent a possible recession, aggregate demand will shift to the ____, the price level will either remain constant or ____, and the level of real GDP will ____.

Answer

a.

right; decrease; increase

b.

right; decrease; decrease

c.

left; decrease; decrease

d.

left; increase; increase

e.

right; increase; increase


11. For a hypothetical economy, the MPS is 0.08 and the MPI is 0.17. If government spending increases by $35 and taxes increase by $35, what will be the net effect on equilibrium income?

Answer

a.

A decrease of $35

b.

An increase of $105

c.

An increase of $35

d.

A decrease of $105

e.

A decrease of $15

1.

12.12. The term fiscal policy refers to

Answer

a.

the adjustment of the GDP for inflation.

b.

the purchase and sale of U.S. government securities to regulate the money supply.

c.

the use of government spending and taxation to influence the level of economic growth and inflation.

d.

the use of fines to penalize unfair business practices.

e.

a policy action by Congress to overrule unpopular budget cuts by the president.


13. If aggregate demand intersects aggregate supply in the vertical range of the aggregate supply curve, then, other things equal, an increase in government spending will

Answer

a.

raise the price level and leave real GDP unchanged.

b.

raise real GDP by the amount indicated by the government spending multiplier and leave the price level unchanged.

c.

raise both real GDP and the price level by a multiple of the initial spending increase.

d.

have no effect on real GDP or on the price level, because all private investment will be crowded out.

e.

lower real GDP by an amount equal to the spending increase and reduce inflation.

14. Which of the following is not a means to finance government spending?

Answer

a.

Government subsidies

b.

Government debt

c.

Capital gains taxes

d.

Personal income taxes

e.

Money creation


15. An automatic stabilizer is

Answer

a.

a change in government spending aimed at achieving a policy goal.

b.

an element of fiscal policy that automatically changes in value as real GDP changes.

c.

an element of monetary policy that automatically changes in value as real GDP changes.

d.

a decrease in tax rates as the economy moves into a recession.

e.

a deliberate change in taxation aimed at increasing real GDP.


16. Budget deficits tend to grow during recessions because

Answer

a.

real GDP growth is zero, which causes neither tax receipts nor government expenditures to grow.

b.

real GDP growth is positive, which reduces both tax receipts and transfer payments.

c.

real GDP growth is negative, which reduces transfer payments in relation to tax receipts.

d.

real GDP growth is negative, which reduces tax receipts in relation to government expenditures.

e.

real GDP growth is positive, which increases tax receipts in relation to government expenditures.

1. Why Niall Ferguson thought that the expansionary fiscal policy (or government deficit) could produce crowding-out effect? You can explain by using the IS-LM model or you can use the logic of loanable funds theory.

Niall Ferguson believed that expansionary fiscal policy could produce a crowding-out effect. Ferguson believed that if the government tried to increase demand during the crisis it would cause the real interest rate to increase. He theorized that if the government tried to boost the economy through deficit spending it would cause the interest rate to rise, which in turn would crowd-out investors and consumers. The interest in the deficit would lead to an increase in the demand for loanable funds, which would lead to an increase in interest rates. Ferguson stated "The lesson of economic growth is very clear. Economic growth does not come from state-led infrastructure investment. It comes from technological innovation, and gains in productivity, and these things come from private sector, not from the state."

2. Why Paul Krugman thinks that Niall Ferguson was wrong and thought that government deficit could not produce a crowding-out effect? In other words, please explain Krugman's Liquidity trap .

Paul Krugman disagreed with Ferguson and believed that the government deficit could not produce a crowding out effect. Krugman's liquidity trap: Private demand is so low that even if the short-term interest rate is 0% spending is less that what is needed for full employment. Normal monetary policy of the central bank purchasing short-term debts with new money is ineffective. Krugman argues that a major issue during the crisis was people wanting to save money combined with the private sector being far less likely to invest. He referred to this a "savings glut". It was argued that the federal reserve was playing the part that the private banking system through buying private securities and the federal government was playing the roll that business wasn't by engaging in investment. Due to the liquidity trap excess demand for savings is not going to drive interest rates up. Krugman stated " Government borrowing gives some of those excess saving a place to go and in the process expands overall demand, and hence GDP. It does not crowd out private spending, at least not until the excess supply of savings has been sopped up, which is the same thing as saying not until the economy has escaped from the liquidity trap."

3. In the discussion, other discussants such as George Soros and Robin Wells pointed out some interesting issues. Please provide at least one thing that you agree and one thing that you disagree. Discuss in details why you think so.

I agree with Soros view that the publics view of the financial markets has been forever changed. " Financial markets namely that they tend toward equilibrium, and that equilibrium is disturbed by extraneous forces, outside shocks. But the finical system collapsed of its own weight." I feel like this is a situation in which it takes a very long time to build trust, but that trust can be lost instantly. The crash has challenged the felling of security that people once felt in the banking system. The idea of the market regulating itself is fading, it wasn't until the government stepped that people felt reassured in the banking system. I believe this will lead to a period of government regulation that wouldn't have arose without this change in view. I disagree with robin Wells' view that the US needs to shift towards protectionism. I believe that free trade is good for everyone as long as there is a comparative advantage. If the US moves toward protections as a result of the deficit it will slow economic growth and place us at a disadvantage compared to countries with free trade. Not to mention consumers in the US will be placed with the burden of higher prices on goods.

Please make comments to the discussion I provided above(at least 300 words). And you can start with "I agree with you on some points... But I disagree with you on some points".

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