Why is it useful to study a closed-economy model?
It is a model of a country that does not interact with the rest of the world (it does not trade with
other countries). It is easier to first understand how a closed economy works, and much of the
economic intuition we will build up for the closed economy case will carry over to an open
economy, where international trade is allowed. For many economic questions, the answers will
not be fundamentally different if we allow this economy to be open.
What is the role of government in the one period closed economy model?
The role of the government in the one period closed economy model is to purchase a given
quantity of consumption goods, G, and finance purchases by taxing the representative consumer.
The government has a special role to play in providing public goods (government expenditures).
Government spending means taking goods from the private sector. G
an exogenous amount.
Government has a budget constraint which is G = T. Government purchases are equal to taxes, in
Can the government run a deficit in the one period model?
No, since this is a one period economic environment, the government’s choices are very limited,
as described by the above government budget constraint. The government cannot borrow to
finance government expenditures, since there is no future in which to repay its debt, and the
government does not tax more than it spends, as this would imply that the government would
foolishly throw goods away. The government budget deficit, which is G- T is always zero in this
What are the endogenous variables in the model?
C (consumption), N
(labour supply), N
(labour demand), T (taxes), Y (aggregate output), w
What are the exogenous variables in the model?
G (government spending), z(total factor productivity), and K (capital stock)
What are the four conditions that a competitive equilibrium must satisfy for this model?
1 The representative consumer chooses C and N
to make himself as well off as possible subject
to his or her budget constraint, given w, T, and dividend income (pi). That is, the representative
consumer optimizes given his budget constraint, which is determined by the real wage, taxes,
and the profits for the consumer receives from the firm as dividend income.
2 The representative firm chooses N