Introduction

Until now, the national income, the price level and the rate of interest have all been treated as given facts -- numbers to be measured, not explained. But why do they take the values they do? Answering that is the basic objective of macroeconomics: to build theoretical tools, called models, that explain what determines the size of these variables -- why an economy slips into a slow-growth or recessionary period, why prices rise, or why unemployment climbs.

Because so many variables interact simultaneously, economists typically isolate one relationship at a time and hold everything else constant -- an assumption known as ceteris paribus ('other things remaining equal'). This mirrors how you would solve two simultaneous equations in two unknowns: solve for one variable in terms of the other from the first equation, then substitute that expression into the second equation to find the full solution.

This chapter applies exactly this approach to explain how national income is determined, under two simplifying assumptions: that the price of final goods is fixed, and that the rate of interest in the economy is constant. The theoretical framework used throughout is the one developed by the British economist John Maynard Keynes.