This is “Overview of National Output Determination”, section 19.1 from the book Policy and Theory of International Economics (v. 1.0).
This book is licensed under a Creative Commons by-nc-sa 3.0 license. See the license for more details, but that basically means you can share this book as long as you credit the author (but see below), don't make money from it, and do make it available to everyone else under the same terms.
This content was accessible as of December 29, 2012, and it was downloaded then by Andy Schmitz in an effort to preserve the availability of this book.
Normally, the author and publisher would be credited here. However, the publisher has asked for the customary Creative Commons attribution to the original publisher, authors, title, and book URI to be removed. Additionally, per the publisher's request, their name has been removed in some passages. More information is available on this project's attribution page.
For more information on the source of this book, or why it is available for free, please see the project's home page. You can browse or download additional books there. You may also download a PDF copy of this book (29 MB) or just this chapter (873 KB), suitable for printing or most e-readers, or a .zip file containing this book's HTML files (for use in a web browser offline).
This chapter describes how the supply and demand for the national output of goods and services combine to determine the equilibrium level of national output for an economy. The model is called the goods and services market model, or just the G&S market model.
In this model, we use gross national product (GNP) as the measure of national output rather than gross domestic product (GDP). This adjustment is made because we wish to define the trade balance (EX − IM) as the current account (defined as the difference between exports and imports of goods, services incomes payments/receipts, and unilateral transfers). This adjustment is discussed in more detail in Section 19.6 "Export and Import Demand".
The diagram used to display this model is commonly known as the Keynesian cross. The model assumes, for simplicity, that the amount of national output produced by an economy is determined by the total amount demanded. Thus if, for some reason, the demand for GNP were to rise, then the amount of GNP supplied would rise up to satisfy it. If demand for the GNP falls—for whatever reason—then supply of GNP would also fall. Consequently, it is useful to think of this model as “demand driven.”
The model is developed by identifying the key determinants of GNP demand. The starting point is the national income identity, which states thatGNP = C + I + G + EX − IM,
that is, the gross national product is the sum of consumption expenditures (C), investment expenditures (I), government spending (G), and exports (EX) minus imports (IM).
Note that the identity uses GNP rather than GDP if we define EX and IM to include income payments, income receipts, and unilateral transfers as well as goods and services trade.
We rewrite this relationship asAD = CD + ID + GD + EXD − IMD,
where AD refers to aggregate demand for the GNP and the right-side variables are now read as consumption demand, investment demand, and so on. The model further assumes that consumption demand is positively related to changes in disposable incomeAll the income households have at their disposal to spend. It is defined as national income (GNP), minus taxes taken away by the government, plus transfer payments that the government pays out to people. (Yd). Furthermore, since disposable income is in turn negatively related to taxes and positively related to transfer payments, these additional variables can also affect aggregate demand.
The model also assumes that demand on the current account (CAD = EXD − IMD) is negatively related to changes in the domestic real currency value (i.e., the real exchange rate) and changes in disposable income. Furthermore, since the domestic real currency value is negatively related to the domestic price level (inflation) and positively related to the foreign price level, these variables will also affect current account demand.
Using the G&S market model, several important relationships between key economic variables are shown:
The G&S market model connects with the money market because the value of GNP determined in the G&S model affects money demand. If equilibrium GNP rises in the G&S model, then money demand will rise, causing an increase in the interest rate.
The G&S model also connects with the foreign exchange (Forex) market. The equilibrium exchange rate determined in the Forex affects the real exchange rate that in turn influences demand on the current account.
A thorough discussion of these interrelationships is given in Chapter 20 "The AA-DD Model".
There is one important relationship omitted in this version of the G&S model, and that is the relationship between interest rates and investment. In most standard depictions of the Keynesian G&S model, it is assumed that increases (decreases) in interest rates will reduce (increase) demand for investment. In this version of the model, to keep things simple, investment is assumed to be exogenous (determined in an external process) and unrelated to the level of interest rates.
Some approaches further posit that interest rates affect consumption demand as well. This occurs because household borrowing, to buy new cars or other consumer items, will tend to rise as interest rates fall. However, this relationship is also not included in this model.
The main results from the G&S model are the following:
Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”