In this figure the initial equilibrium is at point A where indifference curve

In this figure the initial equilibrium is at point a

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In this figure, the initial equilibrium is at point A, where indifference curve I1is tangent to PPF1, the initial PPF. Here, equilibrium consumption is C 1 and equilibrium leisure is l 1 . Therefore, equilibrium employment is N 1 = h – l 1 .The initial equilibrium real wage is negative the slope of the indifference curve at point A. Now, when government spending increases, the PPF shifts to PPF 2 , and the equilibrium point moves to B, where consumption and leisure are both lower at C 2 and l 2 . Consumption and leisure decrease because they are normal goods. Given the normal goods assumption, a negative income effect from the
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downward shift in the PPF must reduce consumption and leisure. Because leisure falls, employment must rise due to N 2 = h – l 2 . Furthermore, because employment increases, the quantity of output rises. With the same quantity of one factor of production (capital), and more of the other (labour), and total factor productivity held constant, output must increase. The income-expenditure identity tells us that Y = C + G therefore C = Y – G , and so C = Y - G Therefore, this shows that Y > 0 and as a result C > - G , so that private consumption is crowed out by government purchases, but it is not completely crowded out as a result of the increase in output. In the figure, the change in G is distance AD, and the change in C is negative the distance AE. A larger government results in more output being produced, because there is a negative income effect on leisure and therefore a positive effect on labour supply. However, a larger government reduces private consumption, through a negative income effect produced by the higher taxes required to finance higher government spending. As the consumer pays more tax, there disposable income will decrease and in equilibrium they will spend less on consumption goods, and work harder to support a larger government. The slope of PPF 2 is identical to PPF 1 for each quantity of leisure. Therefore, because the PPF becomes steeper as l increases (the marginal product of labour increases as employment decreases), PPF 2 at point B will be less steep than PFF 1 at point A. Because the negative slope of the PPF at equilibrium point is equal to the equilibrium real wage, the real wage falls as a result of the increase in government spending. The real wage must fall, as we know that equilibrium rises, and the representative frim would hire more labour only in response to a reduction in the market real wage. A Change in Total Factor Productivity An increase in total factor productivity involves a better technology for converting factor inputs into aggregate output. Increase in total factor productivity increases consumption and aggregate output, but there is an ambiguous effect on employment. This ambiguity is the result of opposing income and substitution effects on labour supply. While an increase in government expenditure essentially produces only an income effect on consumer behaviour,
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an increase in total factor productivity generates both an income effect and a substitution effect.
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