The equilibrium effects of a temporary increase in government spending include
A) an increase in the real wage and an increase in the real interest rate.
B) an increase in the real wage and a decrease in the real interest rate.
C) a decrease in the real wage and an increase in the real interest rate.
D) a decrease in the real wage and a decrease in the real interest rate.
E) real wages and the real interest rate remaining unchanged.

Question

Quizplus · Accepted Answer

A temporary increase in government spending leads to an increase in demand for goods and services, which causes an increase in the price level. As the price level increases, the nominal wage increases but the real wage falls (assuming the increase in the nominal wage is less than the increase in the price level), reducing the quantity of labor demanded and causing unemployment. At the same time, an increase in demand for goods and services increases the demand for money, causing an increase in the interest rate. However, as the real wage falls, workers will more willingly supply labor, which leads to firms increasing production, which will increase the demand for loanable funds, causing the real interest rate to rise. Therefore, the equilibrium effects of a temporary increase in government expenditure are a decrease in the real wage and an increase in the real interest rate.

The Equilibrium Effects of a Temporary Increase in Government Spending