Building Blocks of the Flexible-Price Model

In the precedent two chapters we have looked at long-run growth—at how the economy develops as well as evolves over periods as long as generations. In this chapter we move our point of view and take instead a “snapshot” view of the economy, looking at it over such a short period that its productive resources will be fixed. The major questions we will look for to answer are:

1) What define the equilibrium level of real GDP (Y)?
2) What economic forces continue real GDP (Y) at its equilibrium level?
3) What define the composition of real GDP—that is the division of production and spending between consumption goods (C), investment goods (I government purchases (G), and net exports (NX)?

To respond the first two questions we will presume that wages and prices are adequately flexible that markets clear—that each buyer finds a willing seller and every seller finds a willing buyer. This flexible-price assumption signifies most importantly that supply equals demand in the labor market: no firms wishing to appoint workers are left unsatisfied, as well as no workers who are willing to work are left unemployed. This kind of analysis is a full-employment analysis.

In responding the third question, what define the composition of spending, we will be accumulating the building blocks for the analysis of the following chapter. These building blocks together and show in detail how the answers to the three key questions are consistent, and what are the economic forces that makes sure that a flexible-price economy reaches and stays at its equilibrium.

Potential Output as well as Real Wages:

In the flexible-price mold of the macro economy to be build-up in this section, two sets of factors define the levels of potential (and actual) output and of real wages; the production function as well as the balance of supply and demand in the labor market.

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