N.

Gregory Mankiw

Macroeconomics

Chapter 3:

National Income:
Where it Comes From
and Where it Goes

CHAPTER 3 National Income

In this chapter, you will learn…
 How an economy’s total output/income is
produced
 How the prices of the factors of
production are determined
 How total income is distributed
 What determines the demand for goods
and services (how is total income spent?)
 How equilibrium in the goods market is
achieved
CHAPTER 3 National Income

Outline of model
A closed economy, market-clearing model
Economic Agents
 Households
 Firms
 Government
Markets where these agents interact
 Market for Goods and Services
 Factor Markets
 Financial Markets
The interaction between agents in the context of
markets determines an economy’s resource
allocation and progress

CHAPTER 3 National Income

CHAPTER 3 National Income

and structures used in production L = labor: the physical and mental efforts of workers AND TECHNOLOGY CHAPTER 3 National Income . machines.Who Produces Output? 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  exhibits “constant constant returns to scale” scale CHAPTER 3 National Income .

.Returns to scale: A review Initially Y1 = F (K1 . Y2 = zY1  If increasing returns to scale.g. Y2 = F (K2. L2 )?  If constant returns to scale. Y2 < zY1 CHAPTER 3 National Income . then all inputs are doubled) What happens to output. if z = 2. Y2 > zY1  If decreasing returns to scale. L1 ) Suppose all inputs were to increase by the same factor z: K2 = zK1 and L2 = zL1 (e.

Assumptions of the model 1. 2. The economy’s supplies of capital and labor are fixed at K K and LL Why? Because we are looking at the “long run” where all resources are fully utilized or employed CHAPTER 3 National Income . Technology is fixed.

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

The distribution of national income  determined by factor prices. 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 .

Notation W = 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 3 National Income .

 What about demand? CHAPTER 3 National Income .  Recall: Supply of each factor is fixed.How factor prices are determined  Factor prices are determined by supply and demand in factor markets.

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 . R.Demand for labor  Assume markets are competitive: each firm takes W.

L) CHAPTER 3 National Income .L+1) – F(K.Marginal product of labor (MPL)  definition: The extra output the firm can produce using an additional unit of labor (holding all other inputs fixed): MPL = F(K.

Answers: Marginal Product of Labor MPL (units of output) Output (Y) Production function 60 50 40 30 20 10 12 10 8 6 4 2 0 0 0 1 2 3 4 5 6 7 8 9 10 0 Labor (L) CHAPTER 3 National Income 1 2 3 4 5 6 7 8 9 10 Labor (L) .

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

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

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

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

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

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

CHAPTER 3 National Income .The Cobb-Douglas Production Function  The Cobb-Douglas production function is:  1 Y  AK L where A represents the level of technology  The Cobb-Douglas production function has constant factor shares:  = capital’s share of total income: capital income = MPK x K =  Y labor income = MPL x L = (1 –  )Y .

The Cobb-Douglas Production Function  Each factor’s marginal product is proportional to its average product: Y MPK   AK L  K (1   )Y   MPL  (1   ) AK L  L  1 1 CHAPTER 3 National Income .

How income is distributed: total labor income = MPL  L  (1   )Y total capital income = MPK  K  Y If production function has constant returns to scale. then Y  MPL  L  MPK  K national income labor income CHAPTER 3 National Income capital income .

GDP is approximately 67%.  These shares are roughly constant over long periods of time: fits the Cobb-Douglas Specification. Y  AK 1/ 3 2/3 L CHAPTER 3 National Income . GDP is approximately 33%.S.Empirical estimates of the Cobb-Douglas Production Function  Economists have estimated that the share of capital income in U. .S.33  Labor’s share in U.i.e.  = 0.

The Neoclassical Theory of Distribution  Each factor of production is paid its marginal product  In equilibrium. CHAPTER 3 National Income . MPL = W/P (real wage) MPK = r/P (real rental rate)  Characterized by the Law of Diminishing Returns  Growth in factor productivity should be tracked by the growth in real factor income.

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

Demand for goods & services Components of aggregate demand: C = consumer demand for goods & services I = firms’ demand for investment goods G = government demand for goods & services (closed economy: no exports or imports ) CHAPTER 3 National Income .

Gross Domestic Product [Billions of dollars] Seasonally adjusted at annual rates Source: Bureau of Economic Analysis CHAPTER 3 National Income .

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

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

r  I CHAPTER 3 National Income .Investment. So.  The real interest rate is  the cost of borrowing  the opportunity cost of using one’s own funds to finance investment spending. where r denotes the real interest rate. the nominal interest rate corrected for inflation. I  The investment function is I = I(r).

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

Government spending. G  G = govt spending on goods and services.  Assume government spending and total taxes are exogenous: G G and T T CHAPTER 3 National Income .

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

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

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

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

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

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

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

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

L (YT ) = Y  T . if K = 0. X = “the change in X ”  is the Greek (uppercase) letter Delta Examples:  If L = 1 and K = 0.Notation:  = change in a variable  For any variable X.  Y More generally. so C = MPC  (Y  T ) = MPC Y  MPC T CHAPTER 3 National Income . then MPL  . then Y = MPL.

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

CHAPTER 3 National Income .2 Y  0.Answers S  Y  C  G  Y  0.8 T  G a. S  0.2  Y  0.2  200  40.2  100  20 d.8 (Y  T )  G  0. S   100 b.8  100  80 c. S  0. Y  MPL  L  20  10  200. S  0.

“balanced budget. CHAPTER 3 National Income .. government finances its deficit by issuing Treasury bonds – i.  If T < G.S.” public saving = 0.  If T = G. budget surplus = (T – G) = public saving. borrowing. budget deficit = (G – T) and public saving is negative.Budget surpluses and deficits  If T > G.  The U.e.

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

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 .

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