The Three-Sector Macro Model

Abstract

The ISLM model reduces to only two independent markets or equations and can therefore solve for just two endogenous variables: the level of real output and the interest rate in the Keynesian version; the price level and the interest rate in the neoclassical version. The introduction of the labour market provides a third independent equation and enables one to solve for all three variables: the interest rate, the price level and the quantity of real national output. This chapter outlines the three-sector macro model in which the goods, money and labour markets interact. The behavioural equations which make up the three markets can be reduced in number and summarised in the form of aggregate demand and aggregate supply functions. The aggregate demand function which is derived from the IS and LM equations takes the same basic form in both the neoclassical and Keynesian versions of the model. The fundamental difference between the two approaches lies in their specification of the supply side of the economy, as we have just seen in Chapter 5.