Question

Illustrate the concept of Ricardian equivalence using the demand and supply of financial capital graph.

Short answer

In the Ricardian Equivalence, the deficits don't change the rate because people are rational and that they know that the today's deficits are funded by the taxes tomorrow and thus, the consumers save because they know they need to pay in future also.

Using the graph of demand and provide of capital, it are often explained as done below:

Step-by-step solution

Concept Introduction  

In the case of Ricardian Equivalence, people are forward looking. They know that a cut of charge per unit today will results in increase within the taxes in future so on balance the government budget. This theory means any changes in government deficit would offset the change within the private savings.

Explanation of Solution  

In Ricardian equivalence theory, people try and save the money today so as to pay the taxes in the upcoming future. A tax cut today doesn't result in increase within the aggregate demand in the short run.

1) Life cycle hypothesis

2) Ricardian expectations theory

The economic agents are perfectly rational which implies they know that any increase or decrease in deficit financed government expenditure will ultimately require higher or lower taxes to repay the debt. Consumers are tolerably to balance the spending of present and future.

Initially, the provision and demand for loanable funds intersect at E where the rate is i1 and loanable funds are L 1. When the govt borrowing increases, the mixture demand increases from D 1 to D 1+ DG and also the supply curve remains constant. Thus, the intersection will appear at E1 where the charge per unit increases from i1 to i2.

The high rate results in increase within the quantity supplied of loanable funds and at the identical time, it crowds out the investment of personal sector. This ends up in fall within the quantity demanded for loanable funds and these funds helps to finance the deficit.