Question

A war breaks out that is widely expected to last only one year. Show how the effect of this shock on aggregate output depends on the size of the intertemporal substitution effect of the real interest rate on current leisure, and carefully explain your results.

Answer 1

Answer: When war breaks out ot starts then government increases its spending or various items.It could be equipments required to help in war time operation or it can be such substances which will be required to help out during such situation realted to food etc.

So basically under such condition aggregate femand increases that is its curve shift towards right but not because consumers demanf is increased rather government spending on such item which is required that time.So as cosumers wealth indeed decreases still government spending leads to righward shift in Demand curve.Supply curve will also shift towards righward.

Under such condition aggregate output increases as well as employment increases too but unambiguously.As war is of short time hence Government spending is also of temporary in nature that will not lead to major change in lifetime wealth of consumers rather too small hence Shift in demand curve will be more as compared to supply curve hence Interest rates under such condition goes up i.e. will incraeses.

Hope it helps!