This one is from the Sample questions on the CFA website. 11. According to new classical economists, is financing a reduction in current taxes by government borrowing likely to result in an increase in: aggregate demand? the real interest rate? A. No No B. No Yes C. Yes No D. Yes Yes The answer is A. Can someone explain ? Many Thanks.
Here is the explanation for the first part. Not sure for the real interest rate. Due to govt borrowing money supply has gone down ---->prices has gone up —>Decrease in aggregate demand
sarathk, look for a discussion of the “Ricardian Equivalence” in your books or at http://en.wikipedia.org/wiki/Ricardian_equivalence
also called the Ricardo Barro effect.
When govt borrows, it does so by crowding out private investment, reducing supply of loanable funds, increasing the interest rate. I think the new classical economists suggest that people expect the government to tax later, so they will save more, increasing supply of loanable funds back to the old equilibrium, hence interest rate stays the same, and so does AD
Doesn’t the crowding out effect increase interest rates?
yes, that’s the reason why private investors are “crowded out” as correclty pointed out by yickwong. Please have a look at this too… http://www.analystforum.com/phorums/read.php?11,618191,618191#msg-618191 - Dinesh S
One of the challenges I had with this section is separating what I believe would occur from what the group of people identified in the question thought. New classical economists = no change
This might be really basic and not really analytical, but my thought on classical economists means that there should be no intervention and that the economy will reach its equilibrium naturally. So therefore, if you do anything related to government borrowing, it would have no effect because that’s a third-party intervention. So I would have picked A as well (actually I was working on those last night 
) Feel free to correct me…but I thought that rationale was sufficient.
Very true, dennis2085 … Classical economists felt that markets almost always correct themselves, and no Govt intervention (Fiscal or Monetary) was needed to get back to the long-run-macroeconomic-equilibrium. They also thought that reducing the taxes would reduce the market distortions. - Dinesh S