market simultaneously:
If L.F. market in equilibrium, then
Y
–
C
–
G
=
I
Add (
C
+
G
) to both sides to get
Y
=
C
+
I
+
G
(goods market eq’m)
Thus,
r
adjusts to equilibrate the goods market and
the loanable funds
market simultaneously:
If L.F. market in equilibrium, then
Y
–
C
–
G
=
I
Add (
C
+
G
) to both sides to get
Y
=
C
+
I
+
G
(goods market eq’m)
Thus,
Eq’m in L.F.
market
Eq’m in goods
market
Algebra example
Suppose 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(YT)•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 1250
Use intuition first to make a conjecture.
Verify by algebra:
Y = C + I + G
5000 = 250 + 0.75(50001000) +1000– 5000r +
1250

500
= 5000r,
so
r = 0.10
And
I = 1000 – 5000*(0.10) =
500
.
Investment falls by
250
.
C = 250 + 0.75(5000  1000) =
3250
as 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:
(
)
S
Y
C Y
T
G
G
S
T
C
S
The Reagan deficits cont.
r
2
1
S
2
S
Data
19.9
19.4
variable
1970s 1980s
T
–
G
–2.2
–3.9
S
19.6
17.4
r
1.1
6.3
I
19.9
19.4
T
–
G
,
S
, and
I
are expressed as a percent of GDP
All figures are averages over the decade shown.