Budget Deficit being highly dangerous vs. Ricardian Equivalence The theory of Ricardian equivalence is a theory of Economics by Robert Barro.The theory states that when a government proposes tax cut to increase consumer spending, it leads to a higher budget deficit…
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Those who support this theory base it on the following two assumptions: 1. A budget constraint for the government does not mean that the government will have a deficit forever. A tax reduction or increase in expenditure that leads to spending being higher than revenues means that the deficit will have to be financed through a future tax increase or decrease. 2. The second assumption assumes that consumers are rational and will not increase consumption due to a debt financed tax cut. Their being rational means that they will reduce their consumption, because they understand the government’s fiscal policies that the increase in government spending finance through debt, will lead to higher taxes in future. The above assumptions imply that lower taxes and higher government expenditure through increased debt will not affect the economy as a whole (Alesina & Guido, 1990). There are those economists who are against the Ricardian equivalence and argue that a budget deficit can be extremely dangerous for an economy. According to Ricardians, lower taxes today means higher taxes tomorrow. The opponents see the timing of the expected future tax increase to trickle up to a future generation....
More debt for the government leads to a higher budget deficit (Barro, 1974). Budget Deficit and Public Debt Public debt or government debt is the amount a government owes. A government needs money to finance its expenses. It finances through borrowing from the public by issuing treasury bills or bonds and borrowing from corporations, individuals and foreign governments. The public debt is the outstanding amount borrowed in the past but has not yet been repaid. The size of the public debt is determined by the cumulative amount of borrowing that the government has done. Budget deficit is the excess spending the government has incurred over its income. When the total expenses are subtracted from all income and there is a shortfall, this is known as a budget deficit. The government has spent more money than they can earn. When the income is more than the expenditure this is known as a surplus. The link between budget deficit and public debt is that when a government has a budget deficit it has to get money to finance the deficit and it does this by borrowing which leads to accumulation of more debt. The magnitude of the debt is measured by the debt to GDP ratio (Barro, 1979). Foreign investors will be interested in the debt to GDP ratio, as this clearly indicates the financial position of the economy. A foreign investor will invest in a country that can pay its debt and where the economy is growing. Factors determining an Explosive dynamic Debt to GDP Ratio Public debt increases due to excessive borrowing by the government from issuing treasury bills or bonds and borrowing from foreign governments, individuals and state corporations. GDP is the Gross Domestic Product of an economy and it is the total income from individuals, corporations and the government. Debts are
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