CHAPTER

3

National Income: Where it Comes From and Where it Goes

MACROECONOMICS

SIXTH EDITION

N. GREGORY MANKIW
PowerPoint® Slides by Ron Cronovich
© 2007 Worth Publishers, all rights reserved

In this chapter, you will learn 

what determines the economy¶s total
output/income 

how the prices of the factors of production are
determined 

how total income is distributed  what determines the demand for goods and
services 

how equilibrium in the goods market is achieved
CHAPTER 3

National Income

slide 1

Outline of model
A closed economy, market-clearing model Supply side  factor markets (supply, demand, price)  determination of output/income Demand side  determinants of C, I, and G Equilibrium  goods market  loanable funds market
CHAPTER 3

National Income

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and structures used in production L = labor: the physical and mental efforts of workers CHAPTER 3 National Income slide 3 . machines.Factors of production K = capital: tools.

The production function  denoted Y = F(K. L)  shows how much output (Y ) the economy can produce from K units of capital and L units of labor  reflects the economy¶s level of technology CHAPTER 3 National Income slide 4 .

Y2 = F (K2.g. if z = 1.25. then all inputs are increased by 25%) What happens to output. L1 ) Scale all inputs by the same factor z: K2 = zK1 and L2 = zL1 (e..Returns to scale: A review Initially Y1 = F (K1 . L2 )?  If constant returns to scale  If increasing returns to scale  If decreasing returns to scale CHAPTER 3 National Income slide 5 .

Example 1 F (K . L) ! KL Returns to Scale ? constant returns to scale? increasing returns to scale? decreasing returns to scale? CHAPTER 3 National Income slide 6 .

zL) ! ! ! KL (zK )(zL ) z 2KL z 2 KL ! z KL ! z F (K . L) ! F (zK . L) CHAPTER 3 constant returns to scale for any z > 0 slide 7 National Income .Example 1 F (K .

L) ! K L Returns to Scale ? constant returns to scale? increasing returns to scale? decreasing returns to scale? CHAPTER 3 National Income slide 8 .Example 2 F (K .

zL) ! ! ! .Example 2 F (K . L) ! K L zK  zL z K z L z F (zK .

K  L decreasing returns to scale for any z > 1 slide 9 ! z F (K . L) CHAPTER 3 National Income .

L) ! K 2  L2 Returns to Scale ? constant returns to scale? increasing returns to scale? decreasing returns to scale? CHAPTER 3 National Income slide 10 .Example 3 F (K .

zL) ! (zK )  (zL ) 2 2 ! z 2 . L) ! K 2  L2 F (zK .Example 3 F (K .

L) 2 increasing returns to scale for any z>1 CHAPTER 3 National Income slide 11 .K 2  L2 ! z F (K .

or increasing returns to scale for each of these production functions: (a) F (K . decreasing. L) ! K  L 2 CHAPTER 3 National Income slide 12 .Now you try  Determine whether constant. L) ! K L (b) F (K .

Answer to part (a) K2 F (K . zL) ! zL z 2K 2 ! zL K2 ! z L ! z F (K . L) CHAPTER 3 National Income constant returns to scale for any z > 0 slide 13 . L) ! L (zK )2 F (zK .

L) ! K  L F (zK . zL) ! zK  zL ! z (K  L) ! z F (K . L) constant returns to scale for any z > 0 CHAPTER 3 National Income slide 14 .Answer to part (b) F (K .

2. Technology is fixed. The economy¶s supplies of capital and labor are fixed at K !K and L!L CHAPTER 3 National Income slide 15 .Assumptions of the model 1.

L) CHAPTER 3 National Income slide 16 .Determining GDP Output is determined by the fixed factor supplies and the fixed state of technology: Y ! F (K .

the prices per unit that firms pay for the factors of production  wage = price of L  rental rate = price of K CHAPTER 3 National Income slide 17 .The distribution of national income  determined by factor prices.

Notation W R P = nominal wage = nominal rental rate = price of output W /P = real wage (measured in units of output) R /P = real rental rate CHAPTER 3 National Income slide 18 .

How factor prices are determined 

Factor prices are determined by supply and
demand in factor markets. 

Recall: Supply of each factor is fixed.  What about demand?

CHAPTER 3

National Income

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Demand for labor 

Assume markets are competitive:
each firm takes W, R, and P as given. 

Basic idea:
A firm hires each unit of labor if the cost does not exceed the benefit.  cost = real wage  benefit = marginal product of labor

CHAPTER 3

National Income

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Marginal product of labor (MPL ) 

definition:
The extra output the firm can produce using an additional unit of labor (holding other inputs fixed): MPL = F (K, L +1) ± F (K, L)

CHAPTER 3

National Income

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Determine MPL at each value of L.Exercise: Compute & graph MPL a. Graph the production function. L 0 1 2 3 4 5 6 7 8 9 10 Y 0 10 19 27 34 40 45 49 52 54 55 MPL n. b.a. ? ? 8 ? ? ? ? ? ? ? slide 22 CHAPTER 3 National Income . c. Graph the MPL curve with MPL on the vertical axis and L on the horizontal axis.

Answers: Production unction MPL (u ts o output) Marg al ro u t o Labor 12 10 8 6 4 2 0 0 1 2 3 4 5 6 7 8 9 10 Output (Y) 60 50 40 30 20 10 0 0 1 2 3 4 5 6 7 8 9 10 Labor (L) Labor (L) CHAPTER 3 National Income slide 23 .

L ) MPL 1 MPL 1 MPL 1 Slope of the production function equals MPL As more labor is added. MPL q L labor CHAPTER 3 National Income slide 24 .MPL and the production function Y output F (K .

its marginal product falls (other things equal).Diminishing marginal returns  As a factor input is increased.  Intuition: Suppose oL while holding K fixed   fewer machines per worker   lower worker productivity CHAPTER 3 National Income slide 25 .

10 10 19 9 27 8 34 7 40 6 45 5 49 4 52 3 54 2 55 1 slide 26 CHAPTER 3 National Income . d.Exercise (part 2) Suppose W/P = 6. should firm hire more or less labor? Why? e. If L = 7. If L = 3. should firm hire more or less labor? Why? L 0 1 2 3 4 5 6 7 8 9 10 Y MPL 0 n.a.

L Quantity of labor demanded CHAPTER 3 National Income slide 27 . Labor demand Units of labor.MPL and the demand for labor Units of output Real wage Each firm hires labor up to the point where MPL = W/P. MPL.

equilibrium real wage L MPL. Labor demand Units of labor.The equilibrium real wage Units of output Labor supply The real wage adjusts to equate labor demand with supply. L CHAPTER 3 National Income slide 28 .

The same logic shows that MPK = R/P :  diminishing returns to capital: MPK q as K o  The MPK curve is the firm¶s demand curve for renting capital.Determining the rental rate We have just seen that MPL = W/P. CHAPTER 3 National Income slide 29 .  Firms maximize profits by choosing K such that MPK = R/P .

The equilibrium real rental rate Units of output Supply of capital The real rental rate adjusts to equate demand for capital with supply. demand for capital Units of capital. equilibrium R/P K MPK. K CHAPTER 3 National Income slide 30 .

The Neoclassical Theory of Distribution  states that each factor input is paid its marginal product  is accepted by most economists CHAPTER 3 National Income slide 31 .

then Y ! MPL v L  MPK v K national income CHAPTER 3 labor income capital income slide 32 National Income .How income is distributed: W L ! MPL v L total labor income = P R K ! MPK v K total capital income = P If production function has constant returns to scale.

National Income slide 33 .The Cobb-Douglas Production Function  The Cobb-Douglas production function has constant factor shares: E = capital¶s share of total income: capital income = MPK x K = E Y labor income = MPL x L = (1 ± E )Y  The Cobb-Douglas production function is: Y ! AK L CHAPTER 3 E E where A represents the level of technology.

The Cobb-Douglas Production Function  Each factor¶s marginal product is proportional to its average product: EY MPK ! E AK L ! K (1  E )Y E E MPL ! (1  E ) AK L ! L E 1 1E CHAPTER 3 National Income slide 34 .

Outline of model A closed economy. price) DONE determination of output/income Demand side determinants of C. demand. I. market-clearing model Supply side DONE factor markets (supply. and G Next Equilibrium goods market loanable funds market CHAPTER 3 National Income slide 35 .

Demand for goods & services Components of aggregate demand: C = consumer demand for g & s I = demand for investment goods G = government demand for g & s (closed economy: no NX ) CHAPTER 3 National Income slide 36 .

CHAPTER 3 National Income slide 37 . C  def: Disposable income is total income minus total taxes: Y ± T.  Consumption function: C = C (Y ± T ) Shows that o(Y ± T )   oC  def: Marginal propensity to consume (MPC) is the increase in C caused by a one-unit increase in disposable income.Consumption.

The consumption function C C (Y ±T ) MPC 1 The slope of the consumption function is the MPC. Y±T CHAPTER 3 National Income slide 38 .

 The real interest rate is  the cost of borrowing  the opportunity cost of using one¶s own funds to finance investment spending. So. or   qI CHAPTER 3 National Income slide 39 . I  The investment function is I = I (r ). where r denotes the real interest rate.Investment. the nominal interest rate corrected for inflation.

I (r ) I CHAPTER 3 National Income slide 40 .The investment function r Spending on investment goods depends negatively on the real interest rate.

 G excludes transfer payments (e. social security benefits. G  G = govt spending on goods and services. unemployment insurance benefits).  Assume government spending and total taxes are exogenous: G !G and T !T CHAPTER 3 National Income slide 41 ..Government spending.g.

The market for goods & services  Aggregate demand:  Aggregate supply:  Equilibrium: C (  T )  I (r )  Y ! F (K . L ) Y = C (  )  I (r )  G Y  The real interest rate adjusts to equate demand with supply. CHAPTER 3 National Income slide 42 .

The loanable funds market  A simple supply-demand model of the financial system.  One asset: ³loanable funds´  demand for funds: investment  supply of funds: saving  ³price´ of funds: real interest rate CHAPTER 3 National Income slide 43 .

Consumers borrow to buy new houses. etc. new office buildings.Demand for funds: Investment The demand for loanable funds«  comes from investment: Firms borrow to finance spending on plant & equipment.  depends negatively on r. the ³price´ of loanable funds (cost of borrowing). CHAPTER 3 National Income slide 44 .

Loanable funds demand curve r The investment curve is also the demand curve for loanable funds. I (r ) I CHAPTER 3 National Income slide 45 .

These funds become available to firms to borrow to finance investment spending.Supply of funds: Saving  The supply of loanable funds comes from saving:  Households use their saving to make bank deposits.  The government may also contribute to saving if it does not spend all the tax revenue it receives. purchase bonds and other assets. CHAPTER 3 National Income slide 46 .

Types of saving private saving public saving = (Y ± T ) ± C = T ± G national saving. S = private saving + public saving = (Y ±T ) ± C + = Y ± C ± G T±G CHAPTER 3 National Income slide 47 .

then (Y = MPL. if (K = 0. More generally.Notation: ( = change in a variable  For any variable X. (X = ³the change in X ´ ( is the Greek (uppercase) letter Delta Examples:  If (L = 1 and (K = 0. then MPL ! (Y . (L  ((YT ) = (Y  (T . so (C = MPC v ((Y  (T ) = MPC (Y  MPC (T CHAPTER 3 National Income slide 48 .

8 and MPL = 20. (T c. (L = 100 = 100 = 100 = 10 CHAPTER 3 National Income slide 49 . (G b.EXERCISE: Calculate the change in saving Suppose MPC = 0. (Y d. For each of the following. compute (S : a.

(S ! 0.8 ((Y  (T )  (G ! 0. (Y ! L v (L ! 20 v 10 ! 200.Answers ( S ! (Y  (C  (G ! (Y  0.8 (T  (G a.2 v 200 ! 40. (S ! 0.2 v 100 ! 20 . CHAPTER 3 National Income slide 50 . (S ! 0.2 (Y  0.2 v (Y ! 0.8 v 100 ! 80 c. (S !  100 b.

.digression: Budget surpluses and deficits  If T > G.  If T = G.´ public saving = 0. borrowing.S. government finances its deficit by issuing Treasury bonds ± i.  If T < G. budget deficit = (G ± T) and public saving is negative.e.  The U. budget surplus = (T ± G) = public saving. CHAPTER 3 National Income slide 51 . ³balanced budget.

so the supply curve is vertical. I CHAPTER 3 National Income slide 52 .Loanable funds supply curve r National saving does not depend on r. S ! Y  C (Y  T )  G S.

Loanable funds market equilibrium r S ! Y  C (Y  T )  G Equilibrium real interest rate I (r ) Equilibrium level of investment CHAPTER 3 S. I National Income slide 53 .

then Y±C±G =I Add (C +G ) to both sides to get Y = C + I + G (goods market eq¶m) Thus. market in equilibrium.F.F.The special role of r r adjusts to equilibrate the goods market and the loanable funds market simultaneously: If L. market CHAPTER 3  Eq¶m in goods market slide 54 National Income . Eq¶m in L.

firms must buy new investment goods  tax laws that affect investment  investment tax credit CHAPTER 3 National Income slide 55 .Loanable funds model Things that shift the investment curve  some technological innovations  to take advantage of the innovation.

I National Income slide 56 .An increase in investment demand r «raises the interest rate. CHAPTER 3 I2 I1 S. S r2 r1 An increase in desired investment« But the equilibrium level of investment cannot increase because the supply of loanable funds is fixed.

Saving and the interest rate  Why 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 3 National Income slide 57 .

I slide 58 CHAPTER 3 National Income . which allows I to increase.An increase in investment demand when saving depends on r An increase in investment demand raises r. which induces an increase in the quantity of saving. r S (r ) r2 r1 I(r)2 I(r) I1 I2 S.

CHAPTER 3 National Income slide 59 . then labor income plus capital income equals total income (output).  If the production function has constant returns to scale.Chapter Summary  Total output is determined by  the economy¶s quantities of capital and labor  the level of technology  Competitive firms hire each factor until its marginal product equals its price.

Chapter Summary  A closed economy¶s output is used for  consumption  investment  government spending  The real interest rate adjusts to equate the demand for and supply of  goods and services  loanable funds CHAPTER 3 National Income slide 60 .

CHAPTER 3 National Income slide 61 .  An increase in investment demand causes the interest rate to rise.Chapter Summary  A decrease in national saving causes the interest rate to rise and investment to fall. but does not affect the equilibrium level of investment if the supply of loanable funds is fixed.

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