The new classical model implies that substitution of debt for tax financing
A) increases aggregate demand and exerts an expansionary effect on real output.
B) is highly effective against inflation.
C) reduces savings because it increases both the current and future tax liability of households.
D) leaves wealth, and therefore aggregate demand, unchanged because the debt will require higher future tax rates.

Question

Quizplus · Accepted Answer

According to the new classical model, substitution of debt for tax financing leaves wealth and aggregate demand unchanged because the debt will require higher future tax rates. This is because the expectation of higher future taxes will decrease current consumption and increase current saving, offsetting any short-term increase in spending due to the debt financing. Therefore, there is no net effect on savings or aggregate demand.

The New Classical Model Implies That Substitution of Debt for Tax