Circular Flow with Models of

Behavior
Mankiw, Chapter 3
Consumption
Recall from Circular Flow: Y = C+I+G+NX
Look at Closed Economy, i.e. NX=0 C Consumption
Function
Consumption, C
HHs determine their consumption based on MPC
disposable income, Y-T where T = Taxes. 1
Model HHs behavior as Consumption Function:
C = C(Y-T). Disposable Income Y-T
Assume Marginal propensity to consume,
MPC is constant and 0 < MPC < 1
Other factors also matter.

2
Investment & Government
Real
Investment, I Interest
Rate
Both Firms & HHs Investment depends on the r
Investment
Function
Real interest rate: I = I(r).
Higher interest rate reduces investment level r1
Other factors also matter.
I1 Investment

Government Purchases, G.
Assume Government spending is fixed: G = G0.
Assume taxes & transfer payments are fixed: T = T0.
Government Budget Deficit: D = G - T.

3
Equilibrium in Goods & Services
1. Supply of Output

Market for Goods & Services (Output). Ys = F(K0, L0) = Y0

Supply of Output: 2. Demand for Output

Yd = C + I + G
Ys fixed by factors of production.
C = C(Y-T)
Demand for Output: I = I(r)
Yd comes from C+I+G. G = G0, T = T0
Yd = C(Y-T0) + I(r) + G0
Interest rate reacts to imbalances in Ys
3. Equilibrium
and Yd. Y0= C(Y0-T0) + I(r) + G0
Forces Investment to adjust so demand
Interest rate adjusts to
equals supply. reach equilibrium (Yd=Ys)

4
Recasting the Equilibrium
Recall Y = C + I(r) + G + NX. For a closed economy NX=0.
Rearrange: Y - C - G = I(r) or S = I(r).
S = Y C G + ( T T) = (Y - T - C) + (T - G) = I(r)
or S = I(r).
Natl Saving = Private Saving + Public Saving = (Y - T - C) + (T - G)
Long Run equilibrium at any point of time is then defined by:
Savings equals Investment for economy.
Financial system coordinates S & I through changes in real interest
rate, r.

5
Market for Loanable Funds In Words
Supply of Loanable Funds
Savings depend on income and perhaps interest rate.
Demand for Loanable Funds
Borrowing for investment is source of demand.
Equilibrium in Loanable Funds Market.
Real Interest rate is price of loanable funds.
Interest rate adjusts to equate demand and supply.
Thus automatic adjustments in Market for Loanable Funds
ensures equality of Saving and Investment.

Chapter 3 6
Market for Loanable Funds - Visually
Interest
S(r)
Rate

r1

I(r)

0 L1 Loanable Funds