The Determination of Equilibrium Output

In this chapter we begin our main job of constructing an economic theory which can be used to explain why the economic system behaves as we saw that it did in Chapter 6. We approach this task by developing a model of the economic system. Since the economic system is complicated, the model, to be useful, must necessarily also be complicated. We shall begin, however, by constructing a model of extreme simplicity and introduce complexities later only when the properties of the simple model have been thoroughly understood. Accordingly we start with a system in which (i) there is no government (i.e. no public-sector) economic activity, and (ii) there is no international trade. We also make one additional assumption, namely that the price of a unit of output is constant. This enables us to identify changes in the money values of variables with changes in their ‘real’ values and postpone discussion of the determination of prices. Each of these assumptions is removed later.