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 Y

changeinY
determined by factor inputs (i.e. K and MPL Y F ( K , L)
changeinL
L) only.
Y=F(K,L)
We begin with a production function. Change in Y

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 L
marginal returns to labour. Y
changeinY
MPK Y F ( K , L)
MPL=F(K,L+1)-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 Change in K
unit.
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

2
images we would get a surface 10
0

with output on the vertical axis Output

7.5
5

and capital and labour on the 2.5

0
other axes. 0
2
4
6
Capital 8
10

Y F ( K , L)
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
8
6
0 4
2
0 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 labour
wage) and P (price) are Demand
determined exogenously.
To determine the optimal amount L* L

of 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 (R/P)*
for capital K. MPK = R/P (rental MPK is
rate of capital divided by the price Capital
Demand
level).

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=(1s) is the marginal propensity
to consume. This gives us a consumption function
C = c(YT).
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(YT) + I(r) + G rearranging we get,
Y c(YT) 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(YT) + 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 r
rearrangement of the goods
market into savings and r
investment components. This
rearrangement is called the r*
I(r)
loanable funds market.
If the loanable funds market is out
of equilibrium then the interest S,I(r)
rate adjusts to 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*
I(r)
changes in tax policies that affect r*
investment or home buying
incentives or perhaps S,I(r)
technological innovations that S,I(r) S,I(r)
once they are 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.