Suppose a war breaks out that is widely expected to last only one year. show how the effect of this shock on aggregate output depends on the size of the intertemporal substitution effect of the real interest rate on current leisure, and carefully explain your results.

Answer and Explanation:

Due to war outbreak, government increases their spending temporarily. Hence, this leads to a shift of the output demand curve towards the right. Also, since the government spending would be more, this would be more than the reduction in consumption due to a decrease consumer wealth. Simultaneously, due to a decrease in consumer wealth, this would shift the output supply curve towards the right. Since the effect of consumer wealth is subjected to be small, this puts the demand curve more further as compared to the output supply curve. Thus, the interest rate would increase.

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