Question

Consider an economy that produces output with labor and capital, with those goods allocated to consumption, investment, and government purchases. Suppose the government very temporarily, and unexpectedly, increases its purchases of goods. (Assume the government finances these temporary purchases by issuing additional debt. Assume the government only purchases goods—it does not produce goods, or employ labor directly.) Explain the impact of this increase in government spending in both the goods and labor markets today. What happens to consumption demand, investment demand, aggregate demand, and aggregate supply? What happens to the market-clearing real interest rate, total output, consumption and investment? What happens to labor supply and labor demand? What happens to the market clearing real wage and labor hours? Illustrate graphically

Answer 1

Let us look at the impact of government spending in both the goods and labor market today.

1)With the increase in purchase of goods, the equilibrium in the economy is disturbed. This causes a change in the economy. The increase in demand, will cause the prices of the goods to start increasing.

2) In the labor markets, the initial rise in demand will create a requirement for more labor and the nominal wages will also increase because of this requirement.

3)Now this scenario exists only for short time, once the nominal prices start rising up continuously , the labor prices increases making capital less expensive. So firms will start putting in more capital , till the wages fall down. [Please note this circle keeps on taking place in a growing economy]

Now let us look at the demand and how is it affected

1)Consumption demand: Disposable income determines the consumption demand. With the increase in wages, as discussed above people have more money to spend and the consumption demand goes up.

2)Investment demand: Investment demand depends on the investment in capital,infrastructure etc. Investment can be of two types : autonomous such as government spending on infrastructure and induced: which is brought in by rising income.

In this case as the economy starts progressing with people earning more, aggregate demand gong up, the investment demand will go up as firms spend more on capital to produce more goods and keep up with the aggregate demand.

3)Aggregate demand: This demand is governed by total demand of good and services in the economy at any time. In this scenario as the demand of goods increases the aggregate demand will also rise up.

4)Aggregate Supply: As the aggregate demand goes up, the firms plan on selling a large number of goods. Therefore the aggregate supply of goods and services in the market increases.

5)Market Clearing Interest rate: In a market clearing ideal scenario the demand for loans is equivalent to the supply of loans from lenders. In such cases, the cost of borrowing is neither low or high.

6)Labor Supply and demand: In this example as the demand for labor increases in a thriving economy driven by a demand for goods, so the notional wages go up. Higher wages attract more and more labor and hence the supply of labor increases. [As more and more labor is available to work, the wages go down eventually.]

7) As explained earlier, the market clearing real wage will go up till the supply of labor floods the market and the real wage will fall again back to equilibrium.

8)As wage increases, some of the labor will find work more hours and this becomes the firm expectation. While those companies which will be no longer profitable due to rising wages will utilize fewer labor hours.