Question

Consider an economy that is initially in equilibrium. The government, in order to boost the economy, increases government purchases and fully finances this increase by levying a lump-sum tax on households. Suppose that there is no income effects in labor supply. How does this policy affect the economy

a. In the long run and according to the classical view, real GDP increases.

b. In the short-run and according to the Keynesian view, real GDP decreases.

c. In the short-run and according to the Classical view, real GDP increases and interest rate decreases.

d. In the short-run and according to the Keynesian view, real GDP and interest rate both increase.

Answer 1

ans is d)   In the short-run and according to the Keynesian view, real GDP and interest rate both increase.

Explanation:
As govt purchases increases, this increases wages and fully finances this increase by levying a lump-sum tax on households, this leads to increases wages first ( as govt purchases increases) and as there is no income effects in labor supply, labor supply will also rises, leads to increase in both short run real GDP and interest rate.