A Closed Economy OnePeriod
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
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
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,
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