CHAPTER THREE National Income: Where it Comes FromWhere it …home.cerge-ei.cz/.../VSE/IP410_F09/rc_chapter03_01.pdf · 2009-10-16 · In this chapter you will learn: what determines

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


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


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.


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


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


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


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


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/


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?


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


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)


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)


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


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


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


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 .


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


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


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


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 )


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.


The consumption functionThe consumption function

C

C (Y –T )

MPCThe slope of the

1

MPC consumption function is the MPC.

Y – T


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


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

( )


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


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.


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


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).


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

( )


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.


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


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.


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


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


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


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


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⇔


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


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↓ ⇒ ↑ ⇒ ↓


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


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.


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


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


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?


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


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 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


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.


Documents

CHAPTER THREE National Income: Where it Comes FromWhere it …home.cerge-ei.cz/.../VSE/IP410_F09/rc_chapter03_01.pdf · 2009-10-16 · In this chapter you will learn: what determines