Outline of model Output is determined by the fixed factor supplies and

A closed economy, market-clearing model  Supply the fixed state of technology:

side Y F(K,L)
factor markets (supply, demand, price)
determination of output/income The distribution of national income
 Demand side  determined by factor prices,
determinants of C, I, and G the prices per unit firms pay for the factors of
 Equilibrium goods market production
loanable funds market wage = price of L rental rate = price of K

Factors of production Notation

K = capital: WRP
tools, machines, and structures used in production W /P R /P
L = labor: = nominal wage
the physical and mental efforts of workers = nominal rental rate
= price of output
The production function: Y = F(K,L) = real wage
 shows how much output (Y ) (measured in units of output)
the economy can produce from = real rental rate
K units of capital and L units of labor
 reflects the economy’s level of technology  exhibits How factor prices are determined
constant returns to scale  Factor prices determined by supply and demand in
factor markets.
Returns to scale: a review  Recall: Supply of each factor is fixed.  What about
Initially Y1=F(K1,L1) demand?
Scale all inputs by the same factor z:
K2 =zK1 and L2 =zL1 Demand for labor
(e.g., if z = 1.2, then all inputs are increased by 20%)  Assume markets are competitive: each firm takes W,
What happens to output, Y2 = F (K2, L2 )? R, and P as given.
 If constant returns to scale, Y2 = zY1  Basic idea:
 If increasing returns to scale, Y2 > zY1  If decreasing A firm hires each unit of labor
returns to scale, Y2 < zY1 if the cost does not exceed the benefit.
cost = real wage
Returns to scale: Example 1 benefit = marginal product of labor
F(K,L)  KL
F (zK , zL) Marginal product of labor (MPL)
 (zK )(zL)  z2KL  definition:
 z2 KL  z KL The extra output the firm can produce using an
 zF(K,L) additional unit of labor (holding other inputs fixed):
MPL = F(K,L+1) – F(K,L)
constant returns to scale for any z > 0
MPL and the production function
Returns to scale: Example 2
22
F(K,L)  K L F(zK,zL)  (zK)2 (zL)2
22 2 zKL
 z2 F(K,L)
increasing returns to scale for any z>1

Assumptions
1. Technology is fixed.
2. The economy’s supplies of capital and labor
are fixed at
KK and LL

Determining GDP
Diminishing marginal returns  a good starting point for thinking about income
 As one input is increased (holding other inputs distribution
constant), its marginal product falls.
 Intuition: How income is distributed to L and K
If L increases while holding K fixed
machines per worker falls, worker productivity falls

MPL and the demand for labor

The Cobb-Douglas Production Function

 The Cobb-Douglas production function has constant
factor shares:
α = capital’s share of total income: capital income =
MPK × K = αY
The equilibrium real wage laborincome = MPL×L = (1–α)Y
 The Cobb-Douglas production function is:
 1 YAK L
where A represents the level of technology.

The Cobb-Douglas Production Function

 Each factor’s marginal product is proportional to its
average product:

Determining the rental rate

 We have just seen that MPL = W/P.
 The same logic shows that MPK = R/P:
diminishing returns to capital: MPK falls as K rises
The MPK curve is the firm’s demand curve for Labor productivity and wages
renting capital.  Theory: wages depend on labor productivity  U.S.
Firms maximize profits by choosing K such that MPK data:
= R/P.

The equilibrium real rental rate

The Neoclassical Theory of Distribution

 states that each factor input is paid its marginal
product

Outline of model
A closed economy, market-clearing model
Supply side
 factor markets (supply, demand, price)
DONE 
 determination of output/income
DONE  Demand side
Next  determinants of C, I, and G
Equilibrium
 goods market
 loanable funds market
Demand for goods and 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)
Consumption, C
 def: Disposable income is total income minus total
taxes: Y – T.
Consumptionfunction: C=C(Y–T)
 def: Marginal propensity to consume (MPC) is the
change in C when disposable income increases by one
dollar.
the nominal interest rate corrected for inflation.
The real interest rate is
the cost of borrowing
the opportunity cost of using one’s own funds to
finance investment spending
So, I depends negatively on r
The investment function
Government spending, G
 G = govt spending on goods and services
G excludestransferpayments (e.g., Social Security
benefits,
unemployment insurance benefits)
 Assume government spending and total taxes are
exogenous:
GG and TT
The market for goods & services
 Aggregate demand:  Aggregate supply: 
Equilibrium:
C(Y T)I(r)G Y F(K,L)
Y =C(Y T)I(r)G The real interest rate adjusts
to equate demand with supply.

The consumption function The loanable funds market

 A simple supply–demand model of the financial
system.
Oneasset: “loanablefunds”
demand for funds: supply of funds: “price” of
funds:
investment saving
real interest rate

Demand for funds: Investment

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

Loanable funds demand curve

Investment, I
The investment function is I = I(r) where r denotes
the real interest rate,
Supply of funds: Saving Loanable funds market equilibrium
 The supply of loanable funds comes from saving:
Households use their saving to make bank deposits, The special role of r
purchase bonds and other assets. These funds r adjusts to equilibrate the goods market and the
become available to firms to borrow to finance loanable funds market simultaneously:
investment spending. If L.F. market in equilibrium, then Y–C–G =I
The government may also contribute to saving if it Add (C +G ) to both sides to get Y=C+I+G
does not spend all the tax revenue it receives. (goodsmarketeq’m)
Thus,
Types of saving 
private saving = (Y – T) – C Eq’m in L.F. market
public saving = T – G Eq’m in goods market
national saving, S
= private saving + public saving = (Y–T)–C + T–G Digression: Mastering models
= Y–C–G To master a model, be sure to know:
1. Which of its variables are endogenous and which
are exogenous.
Notation: Δ = change in a variable  For any variable X, 2. For each curve in the diagram, know: a. definition
ΔX = “change in X ” b. intuition for slope
Δ is the Greek (uppercase) letter Delta Examples: c. all the things that can shift the curve
 If ΔL = 1 and ΔK = 0, then ΔY = MPL. 3. Use the model to analyze the effects of each item in
2c.
More generally, if ΔK = 0, then MPL Y. L
Δ(Y−T)=ΔY−ΔT, so Mastering the loanable funds model
ΔC = MPC × (ΔY − ΔT ) Things that shift the saving curve
= MPCΔY – MPCΔT public saving
fiscal policy: changes in G or T
Budget surpluses and deficits private saving
If T > G, budget surplus = (T – G)  preferences
= public saving. tax laws that affect saving
If T < G, budget deficit = (G – T) and public saving is – 401(k)
negative. – IRA
If T = G, balanced budget, public saving = 0.  The – replace income tax with consumption tax
U.S. government finances its deficit by
issuing Treasury bonds–i.e., borrowing.

Loanable funds supply curve

CASE STUDY:
The Reagan deficits
 Reagan policies during early 1980s: increases in
defense spending: ΔG > 0
big tax cuts: ΔT < 0
 Both policies reduce national saving:
Are the data consistent with these results?

Mastering the loanable funds model, continued

Things that shift the investment curve: some
technological innovations
to take advantage some innovations, firms must buy
new investment goods
tax laws that affect investment e.g., investment tax
credit

An increase in investment demand

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?

An increase in investment demand when saving

depends on r