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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.

We have ignored the role of money, the asset with which goods and services are bought and sold. In Chapter 4 and Chapter 5 we discuss how money affects the economy and the influence of monetary policy.
We have assumed that there is no trade with other countries. In Chapter 6 we consider how international interactions affect our conclusions.
We have assumed that the labor force is fully employed. In Chapter 7 we examine the reasons for unemployment and see how public policy influences the level of unemployment.
We have assumed that the capital stock, the labor force, and the production technology are fixed. In Chapter 8 and Chapter 9 we see how changes over time in each of these lead to growth in the economy’s output of goods and services.
We have ignored the role of short-run sticky prices. In Chapter 10, Chapter 11, Chapter 13 and Chapter 14, we develop a model of short-run fluctuations that includes sticky prices. We then discuss how the model of short-run fluctuations relates to the model of national income developed in this chapter.

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.