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      Question

      The Ricardian Equivalence Theorem suggests that a budget

      deficit financed by issuing government bonds will have no effect on aggregate demand. This theorem relies on which critical behavioral assumption?
      A Consumers are liquidity-constrained and cannot save enough to offset future taxes. Correct Answer Incorrect Answer
      B Consumers are forward-looking and fully rational, internalizing the government's budget constraint. Correct Answer Incorrect Answer
      C The Marginal Propensity to Consume (MPC) is equal to zero, regardless of disposable income. Correct Answer Incorrect Answer
      D The government fully sterilizes the bond issuance, preventing money supply expansion. Correct Answer Incorrect Answer

      Solution

      Solution: The Ricardian Equivalence Theorem posits that when the government cuts taxes and finances the resulting deficit by issuing debt, rational consumers anticipate that the debt will eventually have to be repaid through higher future taxes. Mechanism: Consumers view the tax cut as merely deferred taxation. They realize their total lifetime resources have not changed. They, therefore, save the entire tax cut to pay the future tax liability. Result: Private saving rises to exactly offset the drop in public saving (the deficit), leaving national saving and aggregate demand unchanged. This requires consumers to be fully rational and forward-looking (B) and to care about future generations (if the debt is rolled over). Option A describes a condition that violates Ricardian Equivalence.

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