AM12B Concepts

Ricardian Equivalence means that when government SPENDS, then it must raise taxes in order to pay back its spending. This concept makes sense if money is GOLD, for in this case, when the government owes GOLD to someone, then he/she can eventually demand gold payment from the government. But when money is paper (and the promise written on the paper-note is that the Govt promises to pay the bearer the SAME thing he currently has -- that is, another paper note) -- then the government always has the means to do this -- by publishing more notes. So the government does not NEED to raise money to pay its expenses.:

QUESTIONS:

Q 1. Explain how government deficits = Private Sector Profits + Household Savings Explain how if the government does not run a deficit then net savings plus profits must be zero. Since profits drive a capitalist economy, the only way such an economy can function is via debt-driven growth, which mean negative household savings equal to postive private sector profits.

Answer #1: In order to explain this, let’s assume there is only one production firm and it has produced goods using Rs. 1,000 and paid as a factor of payments. After production, 10% mark-up as a profit has been added and goods are for sale for Rs. 1,100. Further, all the produce are necessary food items, just sufficient to feed the given population (The laborers who have produced these goods).

a) Government Deficits = Private Profits + Household Savings: In order to buy the necessary food items for Rs. 1,100, government must run some Emergency / basic life support program, so that people can buy food for themselves. Say the government pours out Rs. 200 in the economy as give food support assistance. Hence, the total cash available is Rs. 1,200. Rs. 1,100 would be used to buy the foods and Rs. 100 would be saved with Households. Further, out of Rs. 1,100, Rs. 100 would be profit of Private Sector. As a result:

Government Deficit (Rs. 200) = Private Profit (Rs. 100) + Household Savings (Rs. 100)

b) No Government Deficit, Private Sector Profit = - Household Savings: Assume, next year same level of production is made, same factor of payments made and received and goods are in the market for sale. However, there is no government food assistance program. In order to buy the food of Rs. 1,100 against the Rs. 1,000 earned this year, the households need Rs. 100 additional. It is only possible if they have previous savings that they had saved last year. Hence they need to de-save Rs 100, or make a negative saving in order to purchase the food. This negative saving is exactly equal to private profits.

Government Deficit (Rs. 0) = Private Profit (Rs. 100) + Net Savings (Rs. -100)

0 = 100 – 100 è 0 = 0

Q 2. Create and explain a simple model in which government deficit spending leads the economy to full employment, and improves welfare for all.

Answer # 2: Assume the case of Thar Deseret. There is land and also labor availability. However due to scarcity of water resources, the extant of labor and land usage is limited. Hence there is underutilized land as well unemployment. Say out of total 100 Acre of land and 200 laborers (2 laborer per acre land), only 50 Acres of land (with the help of 100 Laborers) can be cultivated suing the available water resources. Say the government deficit finances a water reservoir and canal to fill it up and also aqueducts for irrigation. Here, at first stage the deficit financing is going to utilize laborers from the unemployed 100 individuals. These newly employed laborers are going to earn wages which would create demand for consumables / foods and other necessities. At second stage, the availability of water is going to stimulate the land lords to cultivate more land with more labor (beyond previous 50 Acres and already employed 100 Laborers). This is going to create permanent employment in the agriculture. Hence, government deficit financing has helped enhance employment to maximum and also overall welfare has been improved.