SummaryClosed economies are defined as countries that are self-sufficient and autarkic. A widely used analogy by Economics professors is Robinson Crusoe’s island, since Crusoe was unable to trade. This one-man economy is the easiest way to understand closed economies.
Getting to an equilibrium:
- Supply and demand
- Market clearing
- Cobweb model
The IS-LM model:
Market clearing occurs in those market situations in which the amount demanded by consumers equals the amount supplied by firms. In market clearing the equilibrium point has its corresponding equilibrium quantity and an equilibrium price. Economic science has developed several adjustment models to reach this stable point. Léon Walras’ and Alfred Marshall’s models are those mostly studied.
Léon Walras’ model is based on price as the force that motivates the adjustment process towards equilibrium. In moments of an excessive demand, prices will rise and against an insufficient demand a decrease in price will take place. The process of tâtonnement or “groping” will happen until the equilibrium price is reached and then transactions will begin to take place.
On the contrary, Alfred Marshall’s model considers that adjustment occurs via quantity. If the demand price is lower than that of supply, the quantity will decrease. The available quantity will be sold at the different prices that consumers are willing to pay for, until the actual equilibrium is reached.
The walrasian approach makes sense when prices are easily observed (a market with perfect information) and modified, being auctions of almost any kind a good example. When prices can hardly be modified (let’s say, because of adjustment costs such as menu costs), and when it’s easier to modify quantities (when there are excessive inventories), the marshallian approach is more reliable.