Explain Ricardian equivalence, and discuss what implication it might have on the efficacy of expansionary fiscal policy.
Ricardian equivalence states that for a given level of government spending a change in taxes – financed by a deficit – will have no effect on the real economy. It is posited that individuals are forward thinking and rational and realise that a tax break today will have to be paid in the future. Therefore individuals won’t go out and spend this tax cut but will instead save it so that they can smooth consumption.
They will save ΔT.r (tax cut multiplied by real interest rate), acknowledging that the government will have to pay interest on its debt so future taxation will need to incorporate this. [...]