also question 5).
The final outcome of expansionary and contractionary fiscal policies is far from clear and further complications, also in the short run, are explained by the Ricardian equivalence. According to the Ricardian equivalence, an expansionary fiscal policy financed by borrowing can be ineffective also in the short term. The reason lies in the rational expectations of economic agents. They know that borrowing can not be sustained for a long time and that, sooner or later, it has to be financed by a rise in taxes. They expect this and, in anticipation of higher future taxes, they increase saving now, in the period of fiscal expansion. This contraction of private spending offsets the beneficial effects of increased public spending. The empirical evidence of Ricardian equivalence theory is mixed and its limitations can be listed as follows:
i) Taxpayers could decide 'rationally' to pass the burden of the debt to future generations, if public debt can be rolled over for very long periods.
ii) Imperfections in the capital markets could prevent economic agents from behaving rationally.
iii) Reactions appear to be sensitive to the debt size. Ricardian equivalence may apply only when the debt has reached a certain threshold.
Q4 Discuss the ways in which a persistent budget deficit could lead to inflation.
The government has three ways to finance budget deficits and each of those could lead, in certain circumstances, to inflation:
i) Borrowing from private sector. If the budget deficit is financed through borrowing, and if the deficits persist, potential output will be reached and inflation may be initiated. Also, as the debt ratio rises, financial markets could fear that the government may be tempted to 'inflate' its way out of the debt, borrowing from the central bank.
ii) Borrowing from the central bank. If the central bank decides to accommodate fiscal deficits by purchasing government bonds, it releases new money in the economy. The effect of an increase in money supply on inflation is straightforward, as the quantity theory of money shows. Hence, inflation becomes a tax that economic authorities raise to alleviate the public debt burden.
iii) Budget deficits could be financed, alternatively, through a rise in taxation. In this case, the effect on inflation is less direct. Business could be tempted to raise prices to maintain their mark-up, eroded by higher taxes. Moreover, an increase in taxation is often perceived as postponed adjustment; financial markets will punish such a behaviour through an increase in the interest rate attached to government bonds. An inflationary spiral could thus be started.