If Ricardian equivalence holds:
A) taxpayers respond to lower tax rates today with increased savings today.
B) taxpayers respond to lower tax rates today with increased spending today.
C) consumption smoothing is less important than when Ricardian equivalence doesn't hold.
D) changes in fiscal policy are more likely to have a larger impact on aggregate demand.

Question

Quizplus · Accepted Answer

If Ricardian equivalence holds, taxpayers are expected to respond to lower tax rates today by increasing their savings today. This is because they anticipate that the tax cuts will eventually have to be offset by higher taxes in the future, and so they plan to save the money now to pay for the future tax increases.

Answer: C 
 Consumption smoothing refers to the idea that individuals prefer to smooth out their consumption over time, rather than experiencing large fluctuations in consumption from year to year. If Ricardian equivalence holds, however, individuals will be less concerned about the immediate impact of changes in fiscal policy on their current consumption levels, as they will be saving more in anticipation of future tax increases.

Answers B and D are not correct. If Ricardian equivalence holds, taxpayers are not expected to respond to lower tax rates today by increasing their spending today, and changes in fiscal policy are not expected to have a larger impact on aggregate demand, since the effects of changes in government spending will be offset by changes in private savings.

If Ricardian Equivalence Holds