Question

Why does equilibrium real GDP occur where C + Ig = GDP in a private closed economy? What happens to real GDP when C + Ig exceeds GDP? When C + Ig is less than GDP? What two expenditure components of real GDP are purposely excluded in a private closed economy?

Short answer

Equilibrium real GDP equals the total spending in the economy to avoid the problem of overproduction and underproduction.

When total spending exceeds real GDP, firms increase their production to cover the gap.

When total spending is less than real GDP, firms cut down their production to minimize the gap.

Government expenditure and net exports are purposely excluded in a private closed economy.

Step-by-step solution

Step 1. Reason for equilibrium real GDP at C + Ig = GDP

Real GDP is the output produced in an economy, while consumption and gross investment are the private closed economy's total spending (or the income generated from the output).

Equilibrium real GDP is the income generated from the output produced in the economy and is just sufficient to purchase the output. The equilibrium real GDP occurs at C + I_g = GDP to avoid overproduction or underproduction in the economy.

If GDP > C + I_g' it will result in the problem of overproduction. If GDP < C + I_g' it will lead to underproduction in the economy. At these points, the economy is not stable, and there is pressure on prices which affects the demand and supply.

Step 2. Total spending exceeds GDP

When total spending exceeds the production in the economy, the output is consumed faster than it is produced and planned inventories fall short.

The firms can balance the gap between spending and output by increasing production. The increased production will match the demand, and there will be no price pressure that can result in an unstable situation.

Step 3. Total spending is less than GDP

Where real GDP exceeds C + I_g' lower total spending implies that there is not sufficient capacity in the economy to purchase the output, and the firms' unplanned inventories increase.

To minimize unplanned inventories, the firms will have to cut down production. Thus, the total spending and income of the economy are reduced to restore the economy's equilibrium.

Step 4. Excluded expenditure components in a private closed economy

In determining the equilibrium of a private closed economy, government expenditure and net exports are purposely excluded. Government expenditure does not produce any output, it only multiplies the total spending. Also, consumption and investment expenditure are generated from the private sector, and there is no role of the public sector in it.

Net exports include foreign economies in the production and consumption, which drains the domestic income and brings some foreign income in return.The interaction with the foreign economies makes it an open economy model.

Therefore, to study the private and closed economy exclusively, government expenditure and net exports are excluded.