1. unemployment will increase in the short run but the price level will be unaffected in the long run.
2. nothing will happen to either the unemployment rate or the price level because the government does not actually increase the money supply.
3. unemployment will increase in the short-run and the price level will fall in the long run.
4. there will be a permanent change in the unemployment rate.
Choose the correct option.
Option 1 is the correct choice. Given the government's announcement, it is reasonable for workers to expect that nominal aggregate demand will increase. It is therefore in their interest to raise appropriately their reservation wages---since the price level is expected to rise they will have to raise their reservation wages to keep expected real wages from falling. And they can do this without any change in expected waiting time. When the government does not follow through and expand aggregate demand as announced, the higher reservation wages set by workers will price them out of the market and waiting time will be higher than expected. The price level will remain unchanged in the long run because nominal aggregate demand has not changed.
With the passage of time, workers will learn that nominal aggregate demand has not expanded and reservation wages will be lowered back to their initial levels. The unemployment rate will return to its natural level. Although the price level will not increase in the long run, since aggregate demand has not changed, it could rise in the short run as a result of the effect of the higher wages on firm's costs. This price level change will, of course, be temporary because the increase in the nominal wage rate is short-lived.
The natural rate of unemployment will not increase as suggested by option 4 because nothing has happened to change either worker's opportunity costs of searching for jobs or the amount of job turnover in the economy. Job turnover will increase if the pace of technological change increases, for example. The the cost of being unemployed, and incentive to find a job quickly, will fall if, for example, the government provides more generous unemployment insurance benefits. The reduction in the cost of being unemployed will raise the opportunity cost of searching for a job since leisure is made more valuable relative to employment.