Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Studying the standard view


In the standard view, fiscal policy impacts the economy in the short term. Consider the case of a tax cut: a fall in taxes (T) influences both consumption (C) and investment (I).

Consumption should increase because it depends heavily on disposable income:

Logically, reducing taxes increases disposable income and boosts consumption. For example, if taxes are reduced and your monthly take-home pay increases, you probably spend more money, right?

Firms also care about taxes because lower taxes make investment opportunities look more attractive – the firm keeps more of the profit. So lowering taxes by increasing investment makes sense.

These effects – the increasing of consumption and investment – act to increase aggregate demand (AD). As we describe in Chapter 9, in the short run this causes real output and the price level to increase. As time passes and prices become flexible, output returns to its natural level, whereas the price level is permanently higher.

You see a similar story when considering an increase in government

purchases (G), except that this time the effect is directly through G in the AD equation (AD = C + I + G + NX).


Reading about the Ricardian view


The Ricardian view of fiscal policy says something quite radical: not only is fiscal policy ineffective in the long run, but also it’s not very effective in the short run. Here’s why.

Imagine that the government increases government purchases (G) but leaves everything else unchanged. In the standard view of the preceding section, G increases but all other components of AD are unchanged, leading to an overall increase in AD. But is this really reasonable?

The Ricardian view says ‘no’; a smart individual should realise that an increase in G is also an increase in future taxes (remember the intertemporal budget constraint from the earlier section ‘Acknowledging that governments face budget constraints’). So it makes sense for individuals to reduce consumption (C) today in order to cover the future taxes they’ll be made to pay! Thus AD may not increase very much in response to an increase in G. Firms may also reduce investment (I) today in the expectation of higher taxes in the future.

Similarly, if the government decides to decrease taxes (T) and leave everything else unchanged, this action may not have much impact on the economy. A smart individual should realise that a fall in taxes today (with no accompanying fall in government spending) is simply a change in the timing of taxes. After all, if present and future government purchases are unchanged, those same tax revenues will have to be collected at some point. So a fall in T today will be accompanied by an increase in taxes in the future. Thus individuals and firms should leave their consumption (C) and investment (I) unchanged, because taxes haven’t really fallen – only the timing of the taxes has changed!

This idea that people don’t care about the timing of taxes and act to offset the impact of fiscal policy changes is called Ricardian equivalence.