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CHAPTER THREE
National Income:Where it Comes FromWhere it Comes From and Where it Goes
macroeconomicsfifth edition
N. Gregory Mankiw
PowerPoint® Slides by Ron Cronovichy
© 2002 Worth Publishers, all rights reserved
In this chapter you will learn:In this chapter you will learn:
what determines the economy’s total output/incomeoutput/income
how the prices of the factors of production are determinedare determined
how total income is distributed
h t d t i th d d f d dwhat determines the demand for goods and services
h ilib i i th d k t ihow equilibrium in the goods market is achieved
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 1
Outline of modelOutline of modelA closed economy, market-clearing model
S l idSupply side• factor markets (supply, demand, price)
determination of output/income• determination of output/income
Demand sided f C d G• determinants of C, I, and G
Equilibrium• goods market• loanable funds market
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 2
Factors of productionFactors of production
K = capital, tools machines and structurestools, machines, and structures used in production
L = labor, the physical and mental efforts of workers
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 3
The production functionThe production function
denoted Y = F (K,L)
shows how much output (Y ) the economy can produce fromK it f it l d L it f l bK units of capital and L units of labor.
reflects the economy’s level of technology.
exhibits constant returns to scale.exhibits constant returns to scale.
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 4
Returns to scale: a reviewReturns to scale: a reviewInitially Y1 = F (K1 ,L1 )
Scale all inputs by the same factor z:Scale all inputs by the same factor z:
K2 = zK1 and L2 = zL1
(If z = 1.25, then all inputs are increased by 25%)
What happens to output, Y2 = F (K2 ,L2 ) ?
If constant returns to scale, Y2 = zY1
If increasing returns to scale Y > zYIf increasing returns to scale, Y2 > zY1
If decreasing returns to scale, Y2 < zY1
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 5
Assumptions of the modelAssumptions of the modelpp1. Technology is fixed.
2. The economy’s supplies of capital and labor are fixed at
and = =K K L L
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 6
Determining GDPDetermining GDPOutput is determined by the fixed factor supplies and the fixed statefactor supplies and the fixed state of technology:
,= ( )Y F K L
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 7
The distribution of national incomeThe distribution of national income
determined by factor prices, the prices per unit that firms pay for thethe prices per unit that firms pay for the factors of production.
The wage is the price of L ,the rental rate is the price of K.p
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 8
NotationNotation
W = nominal wageW = nominal wage
R = nominal rental rate
P = price of output
W /P = real wage (measured in units of output)
R /P = real rental rate/
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 9
How factor prices are determinedHow factor prices are determined
Factor prices are determined by supply and demand in factor marketsand demand in factor markets.
Recall: Supply of each factor is fixed.
What about demand?
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 10
Demand for laborDemand for laborAssume markets are competitive: each firm takes W, R, and P as giveneach firm takes W, R, and P as given
Basic idea:A fi hi h it f l bA firm hires each unit of labor if the cost does not exceed the benefit.
t lcost = real wagebenefit = marginal product of labor
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 11
Marginal product of labor (Marginal product of labor (MPLMPL))g p (g p ( ))
def:h h f dThe extra output the firm can produce
using an additional unit of labor (holding th i t fi d)other inputs fixed):
MPL = F (K, L +1) – F (K, L)
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 12
answers:answers:
Production function Marginal Product of Labor
40
50
60
utpu
t (Y)
8
10
12
s of
out
put)
20
30
40
Ou
4
6
MPL
(uni
ts
0
10
0 1 2 3 4 5 6 7 8 9 100
2
0 1 2 3 4 5 6 7 8 9 10M
Labor (L) Labor (L)
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 13
The MPL and the production functionThe MPL and the production function
Youtputoutput
F K L( , )
1MPL
A l b i
1
MPL
1 As more labor is added, MPL ↓
MPL
1
Slope of the production f ti l MPL
L1
function equals MPL
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 14
labor
Diminishing marginal returnsDiminishing marginal returns
As a factor input is increased, its marginal d t f ll ( th thi l)product falls (other things equal).
Intuition:↑↑L while holding K fixed
⇒ fewer machines per worker
⇒ lower productivity
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 15
MPLMPL and the demand for laborand the demand for labor
Each firm hires labor Units of output
up to the point where MPL = W/P
p
RealReal wage
MPL, Labor demand
Units of labor, LQuantity of labor
demanded
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 16
demanded
Determining the rental rateDetermining the rental rate
We have just seen that MPL = W/P
The same logic shows that MPK = R/P :
diminishing returns to capital: MPK↓ as K ↑diminishing returns to capital: MPK↓ as K ↑
The MPK curve is the firm’s demand curve for renting capitalfor renting capital.
Firms maximize profits by choosing Kh th t MPK R/Psuch that MPK = R/P .
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 17
The Neoclassical Theory The Neoclassical Theory yyof Distributionof Distribution
states that each factor input isstates that each factor input isstates that each factor input isstates that each factor input isstates that each factor input is states that each factor input is paid its marginal productpaid its marginal productstates that each factor input is states that each factor input is paid its marginal productpaid its marginal product
accepted by most economistsaccepted by most economistsaccepted by most economistsaccepted by most economists
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 18
How income is distributed:How income is distributed:
total labor income =W LP
MPL L= ×
total capital income =
P
R KP
MPK K= ×
If production function has constant returns to scale then
P
scale, then
Y MPL L MPK K= × + ×
laborincome
capitalincome
nationalincome
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 19
income incomeincome
Outline of modelOutline of modelA closed economy, market-clearing modelSupply sideSupply side
factor markets (supply, demand, price)determination of output/income
DONEDONE determination of output/income
Demand sidedeterminants of C I and G
DONE
Next determinants of C, I, and GEquilibrium
goods market
Next
goods marketloanable funds market
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 20
Demand for goods & servicesDemand for goods & services
Components of aggregate demand:
C = consumer demand for g & s
I = demand for investment goodsI demand for investment goods
G = government demand for g & s
(closed economy: no NX )
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 21
Consumption, Consumption, CCdef: disposable income is total income minus total taxes: Y – Tminus total taxes: Y T
Consumption function: C = C (Y – T )Sh th t ↑(Y T ) ↑CShows that ↑(Y – T ) ⇒ ↑C
def: The marginal propensity to g p p yconsume is the increase in C caused by a one-unit increase in disposable income.
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 22
The consumption functionThe consumption function
C
C (Y –T )
MPCThe slope of the
1
MPC consumption function is the MPC.
Y – T
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 23
Investment, Investment, IIThe investment function is I = I (r ),
h d t th l i t t twhere r denotes the real interest rate,the nominal interest rate corrected for inflationinflation. The real interest rate is
the cost of borrowingthe cost of borrowing the opportunity cost of using one’s own funds
to finance investment spending.
So, ↑r ⇒ ↓I
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 24
So, ↑r ⇒ ↓I
The investment functionThe investment function
rSpending on p ginvestment goods is a downward-l i f ti fsloping function of
the real interest rate
I (r )
I
( )
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 25
Government spending, Government spending, GGG includes government spending on goods and services.goods and services.
G excludes transfer payments
Assume government spending and total taxes are exogenous:
= = and G G T T
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 26
The market for goods & servicesThe market for goods & services
Agg demand: ( ) ( )C Y T I r G Agg. demand: ( ) ( )C Y T I r G• − + +
Agg supply: ( )Y F K L• = Agg. supply: ( , )Y F K L• =
Equilibrium: = ( ) ( )Y C Y T I r G• − + +
The real interest rate adjusts t t d d ith lto equate demand with supply.
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 27
What determines the interest rate:What determines the interest rate:TheThe loanableloanable funds marketfunds marketThe The loanableloanable funds marketfunds market
A simple supply-demand model of the financial systemthe financial system.
One asset: “loanable funds”demand for funds: investment
supply of funds: savingpp y g“price” of funds: real interest rate
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 28
Demand for funds: InvestmentDemand for funds: InvestmentThe demand for loanable funds:
• comes from investment:Firms borrow to finance spending on plant & i t ffi b ildi t& equipment, new office buildings, etc. Consumers borrow to buy new houses.
• depends negatively on r , the “price” of loanable funds (the cost of borrowing).
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 29
Loanable funds demand curveLoanable funds demand curve
rTh i t tThe investment curve is also the demand curve fordemand curve for loanable funds.
I (r )
I
( )
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 30
Supply of funds: SavingSupply of funds: SavingThe supply of loanable funds comes from saving:saving:
• Households use their saving to make bank d it h b d d th tdeposits, purchase bonds and other assets. These funds become available to firms to borrow to finance investment spendingborrow to finance investment spending.
• The government may also contribute to i if i d d ll f hsaving if it does not spend all of the tax
revenue it receives.
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 31
Types of savingTypes of saving
private saving = (Y –T ) – C
public saving = T – G
i l inational saving, S= private saving + public saving
= (Y –T ) – C + T – G = Y – C – G Y C G
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 32
The role of the governmentThe role of the governmentThe role of the governmentThe role of the government• When T >G ,
budget surplus = (T –G ) = public saving
• When T <G ,When T <G , budget deficit = (G –T )and public saving is negative. p g g
• When T =G , b d t i b l d d bli i 0budget is balanced and public saving = 0.
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 33
The U.S. Federal Government BudgetThe U.S. Federal Government Budget4
0
P
-4
% o
f GD
P
(T -G ) as a % of GDP -8
-121940 1950 1960 1970 1980 1990 2000
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 34
1940 1950 1960 1970 1980 1990 2000
The U.S. Federal Government DebtThe U.S. Federal Government Debt
100
120 Fun fact: In the early 1990s, nearly 18 cents of every tax dollar went to pay interest on
80
100
GD
P
dollar went to pay interest on the debt.
(Today it’s about 9 cents.)
60
rcen
t of G
20
40Per
01940 1950 1960 1970 1980 1990 2000
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 35
Loanable funds supply curveLoanable funds supply curver ( )S Y C Y T G= − − −
National saving does not d ddepend on r, so the supply curve iscurve is vertical.
S, I
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 36
Loanable funds market equilibriumLoanable funds market equilibriumr ( )S Y C Y T G= − − −
Equilibrium real interest rate
I (r )
S, I
I (r )
Equilibrium level of investment
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 37
of investment
The special role of The special role of rrr adjusts to equilibrate the goods market andthe loanable funds market simultaneously: y
If L.F. market in equilibrium, then
Y C G S IY – C – G = S = IAdd (C +G ) to both sides to get
Y = C + I + G (goods market eq’m)Thus,
’ ’ dThus,
Eq’m in L.F. market
Eq’m in goods market⇔
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 38
Mastering the loanable funds modelMastering the loanable funds model1. Things that shift the saving curve
a public savinga. public saving i. fiscal policy: changes in G or T
b private savingb. private savingi. preferencesii tax laws that affect savingii. tax laws that affect saving
i.e. replace income tax with consumption tax
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 39
CASE STUDYCASE STUDYThe Reagan DeficitsThe Reagan DeficitsThe Reagan DeficitsThe Reagan Deficits
Reagan policies during early 1980s:♦ increases in defense♦ increases in defense
spending: ΔG > 0♦ big tax cuts: ΔT < 0♦ big tax cuts: ΔT < 0
According to our model, both policies reduce national saving:national saving:
( )S Y C Y T G= − − −
G S↑ ⇒ ↓ T C S↓ ⇒ ↑ ⇒ ↓
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 40
1. The Reagan deficits1. The Reagan deficits, cont., cont.
r1S1. The increase in
2S 1Sthe deficit reduces saving…
2S
r
r22. …which causes
the real interest r1rate to rise…
S, I
I (r )
I1I2
3. …which reduces the level of investment
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 41
investment.
Are the data consistent with these results?Are the data consistent with these results?
variable 1970s 1980s
T – G –2.2 –3.9
S 19 6 17 4S 19.6 17.4
r 1.1 6.3
I 19.9 19.4
T–G, S, and I are expressed as a percent of GDP
All figures are averages over the decade shown.
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 42
f g g
Mastering the loanable funds modelMastering the loanable funds model2. Things that shift the investment curve
t i t h l i l i tia. certain technological innovations • to take advantage of the innovation,
firms must buy new investment goodsfirms must buy new investment goodsb. tax laws that affect investment
• investment tax credit• investment tax credit
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 43
An increase in investment demandAn increase in investment demand
An increaser S
An increase in desired investment…r2
…raises the interest rate.
r1
I1
I2
But the equilibrium level of investment cannot increase
S, I
I1cannot increase because thesupply of loanable f d i fi d
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 44
funds is fixed.
Saving and the interest rateSaving and the interest rateWhy might saving depend on r ?
How would the results of an increase in investment demand be different?– Would r rise as much?– Would the equilibrium value of I change?
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 45
An increase in investment demand when An increase in investment demand when saving depends on the interest ratesaving depends on the interest ratesaving depends on the interest ratesaving depends on the interest rate
Real interest rate, rS(r)
1. An increase
2. . . . raises the interest rate . . A
Bin desired investment . . .
I2
3. . . . and raises
I2
I1
Investment Saving I S
equilibrium investmentand saving.
I1
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 46
Investment, Saving, I, S
Chapter summaryChapter summary1. Total output is determined by
how much capital and labor the economy hashow much capital and labor the economy hasthe level of technology
2 C titi fi hi h f t til it2. Competitive firms hire each factor until its marginal product equals its price.
3. If the production function has constant returns to scale, then labor income plus capital income
l l ( )equals total income (output).
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 47
Chapter summaryChapter summary4. The economy’s output is used for
consumptionconsumption (which depends on disposable income)investment (depends on the real interest rate)government spending ( )(exogenous)
5. The real interest rate adjusts to equate th d d f d l fthe demand for and supply of
goods and servicesloanable funds
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 48
loanable funds
Chapter summaryChapter summary6. A decrease in national saving causes the
interest rate to rise and investment to fallinterest rate to rise and investment to fall. An increase in investment demand causes the interest rate to rise, but does not affect ,the equilibrium level of investment if the supply of loanable funds is fixed.
CHAPTER 3CHAPTER 3 National IncomeNational Income slide 49