The traditional view of Debt Short run: Y, u Long run: Y and u back at their natural rates closed economy: r, I open economy: , NX (or higher trade deficit) Very long run: slower growth until economy reaches new steady state with lower income per capita The traditional view is just the viewpoint embodied in the models that students learned in Chapters 3 through 14 of this textbook. This viewpoint is accepted by most mainstream economists.

Ricardian equivalence due to David Ricardo (1820), more recently advanced by Robert Barro According to Ricardian equivalence, a debt-financed tax cut, holding G constant, has no effect on consumption, national saving, the real interest rate, investment, net exports, or real GDP, even in the short run. This section 19.3 and 19.4 in 8th edition and 16.3 and 16.4 in the 7th edition. Government Debt and Budget Deficits.

The logic of Ricardian Equivalence Consumers are forward-looking and base spending on current and expected future income - permanent Income/ Life Cycle Hypothesis Implication - Consumers know that a debt-financed tax cut today (G is held constant) implies an increase in future taxes that is equal in present value terms to the tax cut. The tax cut today (coupled with a tax hike in the future) is merely transitory income. Consumption does not change.

The logic of Ricardian Equivalence Consumers save the full tax cut in order to repay the future tax liability. Result: Private saving rises by the amount public saving falls, leaving national saving unchanged, r unchanged, I unchanged, Y unchanged. A tax cut financed by government debt does not reduce the tax burden, it just reschedules the tax. Deficit financed by debt is equivalent to deficit financed by taxes.

Questions: Suppose consumers understand that the tax cut today is to be followed by a decrease in government spending in the future. Would consumption increase?

Arguments against Ricardian Equivalence Myopia: Not all consumers think so far ahead, some see the tax cut as a windfall or an increase in life time income. Borrowing constraints: Some consumers cannot borrow enough to achieve their optimal consumption, so they spend a tax cut. Future generations: If consumers expect that the burden of repaying a tax cut will fall on future generations, then a tax cut now makes them feel better off, so they increase spending.

Bush 1992 withholding Lower withholding, but pay up in the following April. RE predicts no change in consumption because life time resource(permanent income) was not changed – lower withholding was transitory income. Survey – 57% said would save and 43% spend. Most studies show MPC out of temporary tax change < MPC out of permanent tax change.

Other examples Johnson 1968 tax surcharge. Temporary, people just reduced savings Ford 1974 tax rebate. People just increased saving