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Fundamental inflexibility assumptions: W -- inflexible P -- inflexible i -- inflexible Overriding theme -- Production Responds to Economic Activity (focus on goods and services expenditure)
Simplifying Assumptions
Business Saving = 0 (All private saving is personal saving) Taxes dont depend upon income. T = G (Balanced Budget) NX = 0
A Numerical Example
Y 5 25 45 65 85 105 125 T 5 5 5 5 5 5 5 YD 0 20 40 60 80 100 120 C 10 25 40 55 70 85 100 S -10 -5 0 5 10 15 20 I G 10 5 10 5 10 5 10 5 10 5 10 5 10 5
Why is Y* = 85 an Equilibrium?
Example 1: Suppose Y = 105. Intended Actual C = 85 C = 85 S = 15 S = 15 I = 10 I = 10 + 5 = 15 G= 5 G=5 EP = 100 Note -- Actual S = Actual I
Properties of Equilibrium
No unintended inventory accumulation or depletion. All intentions are realized. Intended Saving = Intended Investment (only at equilibrium). EP = Y
Classical Prediction: Selfcorrecting economy Y* = YN. (Business cycle represents deviations from equilibrium)
Economic Policy
Purpose -- to move Y* closer to YN. Method -- change autonomous expenditure (C0, I0, G0). If economy is sluggish (Y* < YN), increase autonomous expenditure. If economy has accelerating inflation (Y* > YN), decrease autonomous expenditure.
Solving for Y*
Substitute equations (2), (3), (4), (5), and (6) into (1) Y* = C0 + b(Y* - T0) + I0 + G0. Solve for Y* Y* = 1 {C0 + I0 + G0} + -b T0. (1 - b) (1 - b)
The Model Without the Simplifying Assumptions: What Results Are The Same?
Answer -- All the qualitative results are the same!!
Same Results
Equilibrium occurs where Ep = Y. True equilibrium, guided by unintended inventory changes. Y* may be <. >, or = YN. Need for policy if Y* is different from YN. Policy change autonomous expenditure (expansionary or contractionary).
The Model Without the Simplifying Assumptions: What Results Are Different?
More possibilities for policy. -- autonomous net taxes (T0) -- marginal tax rate (t) -- trade policy (NX0) Different multipliers for autonomous spending and net taxes.