3.5 Conclusion

In this chapter we have developed a model that explains the production, distribution, and allocation of the economy’s output of goods and services. The model relies on the classical assumption that prices adjust to equilibrate supply and demand. In this model, factor prices equilibrate factor markets, and the interest rate equilibrates the supply and demand for goods and services (or, equivalently, the supply and demand for loanable funds). Because the model incorporates all the interactions illustrated in the circular flow diagram in Figure 3-1, it is sometimes called a general equilibrium model.

Throughout the chapter, we have discussed various applications of the model. The model can explain how income is divided among the factors of production and how factor prices depend on factor supplies. We have also used the model to discuss how fiscal policy alters the allocation of output among its alternative uses—consumption, investment, and government purchases—and how it affects the equilibrium interest rate.

At this point it is useful to review some of the simplifying assumptions we have made in this chapter. In the following chapters we relax some of these assumptions to address a greater range of questions.

Before going on to these chapters, go back to the beginning of this one and make sure you can answer the four groups of questions about national income that begin the chapter.