ABSTRACT
In this model, decision making takes place recursively, with the decisions pertaining to the optimal level of current government activity being the least informed about the current state of the economy and the least flexible with respect to changes in the current state. In contrast, the decisions in the financial markets are the best informed with respect to the current state and the most flexible in terms of adjusting to changes in the current state. All decisions are made in light of limited information and are based, in part, upon expectations about the future. Each set of plans reflects the best that the decision-makers can do in light of their current information and the constraints facing them at the moment. As prices and production levels change, so do interest rates, exchange rates, spending and the stocks of physical and financial assets held at the end of the period. Technologies evolve over time as relative factor prices change. Mistakes may occur in both the goods and factor markets in that firms may end up producing more or less than the optimal amount and may forecast incorrectly the current supply of potential employees; the governments may produce too much or too little or collect too much or too little in taxes. The solution to this general dynamic-disequilibrium system may involve nonperiodic fluctuations in the key economic variables. Besides summarizing the complete model, our objective in this chapter is to present a detailed analysis of the primary influences at work over time as the world economy moves from state to state. In particular, we shall highlight how changes in beginning-of-period stocks affect current production and prices, which, in tum, affect various excess demands in the financial markets. These, in tum, affect current interest rates and exchange rates, which combine with the production and pricing effects to ultimately determine the end-of-period stocks and scales of plant.
