The analysis developed in the previous chapters can be used to explain how, in a simplified model of a full economy, the level of economic activity is determined, and how this level will respond to given changes in the expenditure plans of the various sectors. One important limitation of the argument developed so far is that, in general, it has proceeded on the assumption that the cost and availability of finance are determined independently of the level of economic activity.

In chapter 6, it was explained that the cost and availability of finance influence economic activity because they have a significant effect upon the level of investment expenditure, and, to a lesser extent, upon consumption expenditure, and this influence was considered in some detail in chapters 8 and 9 respectively. The possible methods whereby the monetary authorities can exercise an influence upon financial conditions were discussed in chapter 7. The analysis of subsequent chapters has been concerned with situations where the cost and availability of finance were assumed to remain constant. This assumption greatly simplified the exposition of the effects of changes in expenditure plans, but it is not in accord with reality, and will now be discarded.

Interaction between the production and financial sectors in a simplified two-sector economy

It was explained in chapter 6 that the cost and availability of finance reflect the willingness of those holding money balances to part with them.