lnc14prime3 (1) - Notes 14. Ricardian Equivalence Theorem...

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Notes 14’’’. Ricardian Equivalence Theorem (RET) A New Classical concept, based on the work of David Ricardo. The idea is that a change in government spending (G) has the same effect—namely, no effect—on real GDP (Y) whether it is funded by a tax increase (balanced budget) or by borrowing (deficit spending). The key assumption is that people are rational and forward looking, and so regard government borrowing today as incurring a future tax liability. Here’s an example. Consider two identical countries, Spruntle and Crunkland. Both have Y = $200 billion this year and have balanced government budgets. Then, each increases government spending by $10 billion for the next fiscal year. Spruntle’s government raises taxes by $10 billion. Crunkland’s leaves taxes unchanged and borrows the $10 billion by issuing government bonds. What will be the effect of these fiscal policies on Y in the two countries? Let T = tax revenues, Y
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