MACROECONOMICSMACROECONOMICS

Chapter 3Chapter 3

National Income: Where National Income: Where It Comes From and It Comes From and

Where It GoesWhere It Goes

22

Sources and Uses of GDPSources and Uses of GDP

How much GDP is produced by the firms How much GDP is produced by the firms in an economy?in an economy?

How the income is divided between labor How the income is divided between labor and capital owners?and capital owners?

Who buys the output of the economy?Who buys the output of the economy?How does the demand for goods and How does the demand for goods and

services match the supply of goods and services match the supply of goods and services?services?

33

How Much GDP?How Much GDP?

Think of the whole economy as a Think of the whole economy as a production function: Y=F(K,L)production function: Y=F(K,L)

In the LONG RUN, markets clear.In the LONG RUN, markets clear.No unemployment in the factor markets.No unemployment in the factor markets.The amount of K and L are thus determined.The amount of K and L are thus determined.

The total amount of Y (GDP=Income) is thus determined.

44

Who Gets What?Who Gets What?

In perfectly competitive factor markets, the In perfectly competitive factor markets, the demand for an input is its marginal demand for an input is its marginal product. product. MPL = MPL = ΔΔY/Y/ΔLMPK = ΔY/ΔK

The supply of a factor was determined to The supply of a factor was determined to be K-bar and L-bar.be K-bar and L-bar.

55

Factor SharesFactor Shares

Q of KQ of L

KL

WR

The demand for capital is the value of the marginal product of capital: P(MPK)The demand for labor is the value of the marginal product of labor: P(MPL)

Explain equilibrium.

At equilibrium R = P(MPK) and W = P(MPL)

WL is labor’s share in $; RK is capital’s share in $

(MPK)P(MPL)P

66

Shares of FactorsShares of Factors

If all the firms are operating in perfectly If all the firms are operating in perfectly competitive markets, then P=AC=MC and competitive markets, then P=AC=MC and economic profits (PQ-WL-RK) is zero.economic profits (PQ-WL-RK) is zero.PQ = WL + RKPQ = WL + RKQ = (W/P)L + (R/P)KQ = (W/P)L + (R/P)KY = (MPL)L + (MPK)KY = (MPL)L + (MPK)K

Senator Paul Douglas noticed that (1920s) Senator Paul Douglas noticed that (1920s) the share of labor in the national income the share of labor in the national income remained constant through the years.remained constant through the years.

77

Shares of FactorsShares of Factors

What kind of a production function would What kind of a production function would pay each factor their marginal products pay each factor their marginal products and the marginal products would remain a and the marginal products would remain a constant share of the total income?constant share of the total income?MPL = MPL = αα(Y/L)(Y/L)MPK = (1-MPK = (1-αα)(Y/K))(Y/K)

Cobb-Douglas production function.Cobb-Douglas production function.

88

Cobb-Douglas Production FunctionCobb-Douglas Production Function

It turns out that a function in the following form It turns out that a function in the following form fulfils the required condition.fulfils the required condition.

11 LAKLY

KK LL KK

1KALY

LLAK

LY

1

LY

LY

11)1( KALKY

KKAL

KY

1)1(

KY

KY )1(

99

Properties of Cobb-DouglasProperties of Cobb-Douglas Constant returns to scale: zY=F(zL,zK)Constant returns to scale: zY=F(zL,zK) Declining marginal products: negative 2Declining marginal products: negative 2ndnd

derivativederivative

L L L

K Y Y

a 2a

b

2b

Y

2Y

Y=F(L,K)

MPL

1010

Who Buys the GDP?Who Buys the GDP?NXGICY

)( TYCC )(rII _

GG

For simplicity, let’s assume that NX=0If labor and capital are fixed, Y is fixed.So, the only variable that determines how demand will match supply is r.

HHSTCY

GTS GOV

GOVHH SSI

GCYS

TCYGTS

SSS HHGOV

But from Y = C + I + GI = Y – C – G

1111

Circular FlowCircular Flow

Identify the arrows. Domestic production (GDP) = Expenditures

Income = Expenditures Savings = InvestmentAll equalities imply market clearing.

1212

Another View of EquilibriumAnother View of EquilibriumExpenditures

Y

C=c(Y-T)

C+I+G

Y-bar

1313

Equilibrium in the Financial MarketsEquilibrium in the Financial Markets

rS

I

GOVHH SS What happens if government budget has a deficit?

What happens if investment demand rises?

What happens to investment demand during recessions?