and the output supply curve in figure b shifts to the right from Y s 1 to Y s 2

And the output supply curve in figure b shifts to the

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), and the output supply curve in figure (b) shifts to the right from Y s 1 to Y s 2 . To determine the equilibrium effects of using this model we start with figure (b). It is clear that a current aggregate output must increase, as both the output demand and output supplt curves shift to the right, and so Y increases from Y 1 to Y 2 . It may appear that the real interest rate may rise or fall; however, there is strong theoretical support for an increase in the real interest rate. This is because the temporary increase in government spending should lead to only a small decrease in lifetime wealth for the consumer, which will produce a small effect on labour supply. Therefore, there should be only a small shift to the right in Y s curve, and the real interest rate will rise as in figure (b). The next step is to work out the effects of the increase in the real interest rate for the labour market. In figure (a), given the initial interest rate r 1 , the labour supply curve shifts from N s 1 ( r 1 ) to N s 2 ( r 1 ), because of the negative wealth effect arising from the increase in the present value of taxes. With an increase in the equilibrium real interest rate to r 2 , the labour supply curve shifts further to the right to N s 2 ( r 2 ). Therefore, the equilibrium real wage falls from w 1 to w 2 . Important points for this question: The total multiplier – the ratio of the equilibrium increase in Y, to the increase in G – must be less than 1.
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In rudimentary Keynesian analysis, the multiplier is greater than 1. Why? That type of analysis does not take account of: (i) how the extra output is to be produced; (ii) the effect of taxes (present and future) on consumption. But Keynesian analysis also has sticky prices or wages, typically – see Chapter 14.
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