Comparative Statics as a Method of Analysis and equilibrium in the flexible-price model

Comparative Statics as a Method of Analysis:

The flexible-price and full-employment model we have built in the last two chapters gives us the capability to determine the level as well as composition of real GDP and national income. If we know the economic environment as well as economic policy, we can utilize the model to determine the equilibrium real interest rate, either by answer the algebraic equations or by drawing the flow-of-funds diagram and looking for the point where supply balances demand or both. We can then compute the equilibrium values of a large number of economic variables—real GDP, consumption spending as well as imports and exports, investment spending, the real exchange rate and more. In fact three of the six major economic variables—real GDP and the exchange rate and the real interest rate—come directly from the model. We will see how to compute the price level and inflation rate. In a flexible-price model similar to this one the unemployment rate isn’t interesting, for the economy is for all time at full employment. And we have observed that the stock market is proportional to and a leading indicator of investment spending.

Nevertheless the model therefore far gives us the capability not just to compute the current equilibrium position of the economy, however how that equilibrium will change in response to changes in the economic environment or in economic policy. To do so we utilize a method of analysis economists call comparative statics. We find out the response of the economy to some particular shift in the environment or policy in three steps. We initially look at the initial equilibrium position of the economy without the shift. We then look at the equilibrium position of the economy with the shift. We then recognize the difference in the two equilibrium positions as the change in the economy in response to the shift.

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