Explain the macroeconomic effects of a tax cut according to the Ricardian Equivalence proposition. Include in your answer the IS-LM graph that shows the effects of this tax cut.

What will be an ideal response?

ANSWER:

The Ricardian Equivalence proposition describes the effects of, for example, tax cuts. A tax cut will have no effect on the demand for goods according to the Ricardian Equivalence proposition. A tax cut in the current period will cause an increase in the budget deficit. At some point in the future, say one year, taxes will have to increase to pay off this debt. Individuals will realize this. Once they do, they will realize that the current period tax cut is equivalent to a future period tax increase of the same present value. Hence, they realize that their wealth does not increase as a result of this tax cut. So, they do not increase consumption. In fact, they simply save all of the tax cut. In terms of the IS-LM model, the tax cut does not increase consumption or demand. So, the IS curve does not shift and there is no change in output or the interest rate.