 # 4. Introduction to the Equilibrium Model

### Contents

1. The Parsimonious Model
2. What Is An Equilibrium Model?
3. Equilibrium Model Solution Method
4. Simple Equilibrium Model in Action

### 2. What Is An Equilibrium Model?

1. Suppose that the real GDP of an economy is \$25 billion and that businesses realize that their inventories are higher than they would like. What will occur according to the simple macroeconomic equilibrium model?

a. reduction of the production level of businesses
b. increase in the production level of businesses
c. an increase in real GNP
d. temporary expansion of the level of employment

Answer: A. An undesired inventory increase occurs because total output exceeds total demand. This situation should be reversed by a reduction in output. Answers (b), (c), and (d) imply an increase in output, which would cause inventories to rise even further.

2. At a national income level below the level of aggregate demand:

a. total output exceeds total expenditures.
b. inventory accumulation occurs.
c. pressures exist in the system to expand output.

Answer: C. We generally assume that national income is equivalent to aggregate output. When national income (output) is less than aggregate demand there will be an undesired decline in the level of inventories. An undesired decline in inventories should lead firms to increase output.

### 4. Simple Equilibrium Model in Action

Using the equations describing a simple economy with government and foreign trade:

AD = C + I + G + NX
YD = C + S
YD = Y + TR - TA

and the equilibrium result for model:

AS - I - NX = G + TR - TA

1. If the government budget deficit increases, which of the following can happen?

a. an increase in savings
b. a decrease in savings
c. a decrease in investment
d. private domestic savings increases relative to private domestic investment
e. imports increase
f. exports increase
g. net exports decline
h. savings and exports increase

Answer: (a), (c), (d), (e), (g). Use the equilibrium model result:

G + TR - TA = S - I - NX

If the left hand side of the equation increases (higher government budget deficit) then the right hand side of the equation must also increase. S must increase, or I must becomes smaller, or NX must become smaller (i.e., exports smaller or imports larger).

The answers relate to Ricardian equivalence (a) and (d), crowding out (c), and the twin deficits (e) and (g).

2. An increase in taxes (while government transfers remain constant) must imply a change in net exports, government purchases, or the saving-investment balance.

Answer: True. Use the equilibrium model result:

G + TR - TA = S - I - NX
or,
TR - TA = (S - I) - G - NX

Since TR is constant, an increase in TA implies the left-hand side of the equation becomes more negative. If TA increases, net exports may increase (i.e., imports decline), government spending may increase, and/or savings decline relative to investment. Again, this answer relates to Ricardian equivalence, crowding out and the twin deficits