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Chapter 5

Chapter 5

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University of Maryland
ECON 325
Sadik Arouba

A Closed Economy One­Period Macroeconomic Model How unconstrained markets can produce economic outcomes that are socially efficient. Social efficiency proves to be useful in how we use our model to analyze some important macroeconomic issues. How increases in government spending increase aggregate output and crowd out private consumption expenditures and how increases in productivity lead to increases in aggregate output and the standard of living. In this model where the economic outcome in an economy with unconstrained private markets is not socially efficient since government tax collection distorts private decisions. This enables us to explore how the incentive effects of the income tax matter for aggregate economic activity. The optimal size of the government will be studied. The interaction of consumers are firms in a closed economy--a model where a single, that is, this country doesn’t trade with other countries. country has no interaction with the rest of the world are examined in this model. This economy consists of three different actors: ➔ the representative consumer (sells labor and buys goods) ➔ the representative firm (buys labor and sells goods) ➔ the government Government The behavior of the government in this model is to purchase a given quantity of consumption goods, G, and these purchases are financed through taxing the representative consumer. Economists believe that the government has a special role to play in the provision of public goods. In this model, the assumption is that the government uses up resources through taking goods from the private sector. Output is produced from the private sector and the government purchases an exogenous amount G of this output with the remainder produced by the representative consumer. An exogenous variable is determined outside the model, while an endogenous variable is determined by the model. In experiments, we are interested in what happens to the endogenous variables, when there are changes in the exogenous variables. Government spending is exogenous since it is considered to be independent of what is occurring in the rest of the economy. The government must abide by the government budget constraint which is G = T (in real terms). This brings us to Fiscal policy--government’s choices over its expenditures, transfers, taxes, and borrowing. Government expenditures are purchases of final goods and services. Transfers are real locations of purchasing power from one set of individuals to another. In this model, the government doesn’t borrow, whatever it purchased and remained unused is thrown away, and the budget deficit is always zero. Therefore, the only element of fiscal policy studied in this model is G, that is, government expenditures. Competitive Equilibrium Given these economic agents’ actions, how is consistency obtained in this model? Mathematically, the macroeconomic model takes the exogenous variables (which are determined outside the model) and determines the values for the endogenous variables. The exogenous variables in this particular model are G, Z, and K (that is, government spending, total factor productivity, and capital stock of the economy). The endogenous variables are C, N , N , T, Y, and w (that is, consumption, labor supply, labor demand, taxes, aggregate output, and the market real wage. This model will be used to determine how changes in the exogenous variables affect the endogenous variables. Consistency means that given the market prices, demand is equal to supply in each market in the economy--that is, competitive equilibrium. Competitive refers to the fact that all consumers and firms are price-takers, and the economy is in equilibrium when the actions of consumers and firms are consistent (or competitive equilibrium can vMarkets cle
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