market simultaneously: If L.F. market in equilibrium, thenY– C– G = IAdd (C +G ) to both sides to getY= C+ I+ G(goods market eq’m)Thus, radjusts to equilibrate the goods market andthe loanable funds market simultaneously: If L.F. market in equilibrium, thenY– C– G = IAdd (C +G ) to both sides to getY= C+ I+ G(goods market eq’m)Thus, Eq’m in L.F. marketEq’m in goods market
Algebra exampleSuppose an economy characterized by:•Factors market supply: •labor supply= 1000•Capital stock supply=1000•Goods market supply: •Production function: Y = 3K + 2L•Goods market demand: •Consumption function: C = 250 + 0.75(Y-T)•Investment function: I = 1000 – 5000r•G=1000, T = 1000
Algebra example cont.Given the exogenous variables(Y, G, T), find the equilibrium values of the endogenous variables(r, C, I)
Algebra example cont.Suppose government spending rises by 250 to 1250Use intuition first to make a conjecture.Verify by algebra:Y = C + I + G5000 = 250 + 0.75(5000-1000) +1000– 5000r + 1250-500 = -5000r, so r = 0.10And I = 1000 – 5000*(0.10) = 500.Investment falls by 250.C = 250 + 0.75(5000 - 1000) = 3250as before for this consumption function.
Case study: Reagan deficits•Reagan policies during early 1980s:¨increases in defense spending: G > 0¨big tax cuts: T < 0•According to our model, both policies reduce national saving:()SYC YTGGS TCS
The Reagan deficits cont.r21S2S
Data19.919.4variable1970s 1980sT– G–2.2–3.9S19.617.4r1.16.3I19.919.4T–G, S, and Iare expressed as a percent of GDPAll figures are averages over the decade shown.