Question

Compare the effects of a temporary and a permanent increase in total factor
productivity on output, employment, real wage, real interest rate, consumption
and investment.

Answer 1

A temporary increase in total factor productivity increases output and employment, raises real wages and lowers the real interest rate. As a result, consumption and investment both increases.

A permanent increase in total factor productivity leads to an unambiguous increase in output and employment. The real variables i.e. the real interest rate and real wages, may either rise or fall. Investment may increase only as long as the direct effect of an increase in the marginal product of capital outweighs the increase in interest rates.

Similarly, as long as the direct effect of an increase in current and future income outweighs the possible rise of real interest rate, consumption will also increase.