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The IS–LM model shows the relationship between interest rates and output in the short run in a closed economy. The intersection of the " investment – saving " (IS) and " liquidity preference – money supply " (LM) curves illustrates a " general equilibrium " where supposed simultaneous equilibria occur in both the goods and the money markets.
In most simple microeconomic stories of supply and demand a static equilibrium is observed in a market; however, economic equilibrium can be also dynamic. Equilibrium may also be economy-wide or general, as opposed to the partial equilibrium of a single market. Equilibrium can change if there is a change in demand or supply conditions.
In this simple economic model with a closed economy there are three uses for GDP (the goods and services it produces in a year). If Y is national income (GDP), then the three uses of C consumption, I investment, and G government purchases can be expressed as:
In its most basic form it considers a simple economy consisting solely of businesses and individuals, and can be represented in a so-called "circular flow diagram." In this simple economy, individuals provide the labour that enables businesses to produce goods and services. These activities are represented by the green lines in the diagram. [5]
In economics, general equilibrium theory attempts to explain the behavior of supply, demand, and prices in a whole economy with several or many interacting markets, by seeking to prove that the interaction of demand and supply will result in an overall general equilibrium.
These experts warn that misplaced confidence can be dangerous.
In the general equilibrium model savings must equal investment for the economy to clear. [2] The economy grows as division of labor increases productivity of laborers. This increased productivity in laborers creates a surplus that will be split between capitalists’ expenditure on goods for themselves and investment in other capital. [ 5 ]
In the simplest exposition of Keynesian theory, the economy is assumed to be closed (which implies that NX = 0), and planned investment is exogenous and determined by the animal spirits of investors. Consumption is an affine function of income, C = a + bY where the slope coefficient b is called the marginal propensity to consume .