The Closed

Economy

How the real interest rate keeps the

goods market in equilibrium
Y = C + I(r) + G
 Model Background

• This model is closed in the sense that there are no

exports or imports in the model. The model does include
government tax and government expenditure.
• If the model is out of equilibrium it is the changing real
interest rate that returns the model to equilibrium.
Y > C + I(r) + G => interest rate decreases => I increases until Y = C + I(r) + G.

Y < C + I(r) + G => interest rate increases => I decreases until Y = C + I(r) + G.

• The left hand side of the goods market represents supply

• The right hand side represents demand.

Supply Y = C + I(r) + G Demand

 Building the Goods Market Model: supply side

• This is a long run model so output Y is determined by Y

changeinY
factor inputs (i.e. K and L) only.
MPL = Y = F ( K , L)
changeinL
Y=F(K,L)
Change in Y
• We begin with a production function.
• For simplicity we assume K is fixed and
allow L to vary. Change in L
• We get a functional form that is increasing
at a decreasing rate. This is consistent with
the idea of diminishing marginal returns to L
labour. Y
changeinY
MPL=F(K,L+1)-F(K,L) MPK = Y = F ( K , L)
changeinK
• The slope of this function is the marginal
product of labour. Change in Y

• It tells us the change in output that results

when we increase labour by one unit. Change in K

• We might also assume L is fixed and allow

K to vary. K
Building the Goods Market Model: supply side

10
•
Labor
If we chose to combine these 4
6
8

images we would get a surface

2
0
10

with output on the vertical axis 7.5

Output 5

and capital and labour on the 2.5

0
other axes. 0
2
4
6
Capital 8
10

(
YY==FF( KK, ,LL))
0
2
• In this case a cross section of 4
6
the surface would provide us 8
10
with the two-dimensional
production functions. 10
7.5
Output 5
2.5 10
6 8
0 4
0 2
Labor
Building the Goods Market Model: supply side
Real
Wage
• Factor demand is the marginal
product of that factor. labour
demand, for example, is defined
as the MPL.
• The real wage W/P is the real price (W/P)* MPL is
of labour. Where W (nominal wage) labour
and P (price) are determined Demand
exogenously.
L
• To determine the optimal amount of L*
L, firms add L until the Real
Rental
MPL = W/P. Rate
• This is the profit maximization
process that ultimately determines
output.
• The process is exactly the same for (R/P)*
capital K. MPK = R/P (rental rate of MPK is
capital divided by the price level). Capital
Demand

K* K
Building the Goods Market Model: demand side

• We begin with consumption, investment, and government expenditure.

(net exports are not included in the closed model). This gives us the following
national income accounting identity.
Y = C + I(r) + G …We know Y=F(K,L)
• Now, given a savings rate “s” we say c=(1–s) is the marginal propensity
to consume. This gives us a consumption function
C = c(Y–T).
• “r” is the real interest rate. Investment and the real interest rate have a
negative relationship so I(r) is negatively sloped. As “r” increases “I”
decreases.
• “T” is the amount of tax collected. From this we get…
• Y = c(Y–T) + I(r) + G …rearranging we get,
Y – c(Y–T) – G = I(r) …or,
Sn = I(r) …so national savings = investment
Goods Market Equilibrium: The Loanable Funds Market

• We said the closed economy

model long run equilibrium occurs
at the point where
Y = c(Y–T) + I(r) + G and that if the
system is out of equilibrium then
“r” must change to equilibrate the r
S
system.
• Recall that S = I(r) is just a rearrangement r
of the goods market into savings and
investment components. This r
rearrangement is called the loanable funds
market.
r*
I(r)

• If the loanable funds market is out of

equilibrium then the interest rate adjusts to S,I(r)
equilibrate it which in turn ensures that the
goods market is in equilibrium.
 The Markets in Transition

• There are various effects which

can enter the model and change r
S S
either S or I leading to a change in
the real interest rate.
r*
• Things that might shift S include
changes in Y, T, G, or the mpc. I(r)
• Things that might shift I include r*
changes in tax policies that affect r* I(r)

investment or home buying

incentives or perhaps technological S,I(r)
innovations that once they are S,I(r) S,I(r)
developed firms must invest in to
stay in a market.
• All these changes require a different
interest rate to equilibriate the
market.
 Conclusion

• The closed economy model is a simple

static model that allows us to see how the
real interest rate adjusts to keep equilibrium
in the loanable funds market which implies
equilibrium in the goods market. We also
see how various exogenous shocks can
affect either S or I and therefore lead to a
different real interest rate that equilibrates
the goods market.