National Income: Where It Comes

From and Where It Goes

Parkin: Chapter 7 + Mankiw: Chapter 3

 CONSUMPTION
Households receive income from their labor and their ownership of capital, pay taxes to the
government, and then decide how much of their after-tax income to consume and how much to
save. We define income after the payment of all taxes, to be disposable income. Households divide
their disposable income between consumption and saving. We assume that the level of consumption
depends directly on the level of disposable income. A higher level of disposable income leads to
greater consumption.

The marginal propensity to consume (MPC) is the amount by which consumption changes when
disposable income increases by one dollar. The MPC is between zero and one: an extra dollar of
income increases consumption, but by less than one dollar. Thus, if households obtain an extra dollar
of income, they save a portion of it. For example, if the MPC is 0.7, then households spend 70 cents
of each additional dollar of disposable income on consumer goods and services and save 30 cents.
 INVESTMENT
Both firms and households purchase investment goods. Firms buy investment goods to add
to their stock of capital and to replace existing capital as it wears out. Households buy new
houses, which are also part of investment.
Physical capital is the tools, instruments, machines, buildings, and other items that have been
produced in the past and that are used today to produce goods and services. Inventories of
raw materials, semi-finished goods, and components are part of physical capital. When
economists use the term capital, they mean physical capital. The funds that firms use to buy
physical capital are called financial capital.

The quantity of capital changes because of investment and depreciation. Investment increases
the quantity of capital and depreciation decreases it. The total amount spent on new capital is
called gross investment. The change in the value of capital is called net investment. Net
investment equals gross investment minus depreciation.
 FINANCIAL CAPITAL MARKETS
Saving is the source of the funds that are used to finance investment, and these funds are supplied and
demanded in three types of financial markets:

• Loan markets
Businesses and households can get loan from a bank, often in the form of outstanding credit card balances.
A loan can be secured by a mortgage—a legal contract that gives ownership of a home to the lender in the
event that the borrower fails to meet the agreed loan payments

• Bond markets
A bond is a promise to make specified payments on specified dates. When a person buys a newly issued
bond, he or she may hold the bond until the borrower has repaid the amount borrowed or sell it to someone
else. Bonds issued by firms and governments are traded in the bond market. The term of a bond might be
long (decades) or short (just a month or two).

• Stock markets
A stock is a certificate of ownership and claim to the firm’s profits. Unlike a stockholder, a bondholder does
not own part of the firm that issued the bond. A stock market is a financial market in which shares of stocks
of corporations are traded.
 THE MARKET FOR LOANABLE FUNDS
The loanable funds market is the aggregate of all the individual financial markets.

The flows of funds that finance investment. They come from three sources:

1. Household saving
2. Government budget surplus
3. Borrowing from the rest of the world
Saving is the supply of loanable funds—households lend their saving to investors or deposit their saving in a bank
that then loans the funds out. Investment is the demand for loanable funds—investors borrow from the public
directly by selling bonds or indirectly by borrowing from banks. Because investment depends on the interest rate,
the quantity of loanable funds demanded also depends on the interest rate.

The interest rate adjusts until the amount that firms want to invest equals the amount that households want to save.
If the interest rate is too low, investors want more of the economy’s output than households want to save.
Equivalently, the quantity of loanable funds demanded exceeds the quantity supplied. When this happens, the
interest rate rises. Conversely, if the interest rate is too high, households want to save more than firms want to invest;
because the quantity of loanable funds supplied is greater than the quantity demanded, the interest rate falls.

The equilibrium interest rate is found where the two curves cross. At the equilibrium interest rate, households’ desire to
save balances firms’ desire to invest, and the quantity of loanable funds supplied equals the quantity demanded.
The quantity of loanable funds demanded is the total
quantity of funds demanded to finance investment, the
government budget deficit, and international
investment or lending during a given period.

The quantity of loanable funds supplied is the total

funds available from private saving, the government
budget surplus, during a given period.
Changes in the Demand for Loanable Funds

• Expected Profits: Other things remaining the same, the greater the expected profit from new capital,
the greater is the amount of investment and the greater the demand for loanable funds.

Changes in the Supply of Loanable Funds A change in disposable income, expected future income,
wealth, or default risk changes the supply of loanable funds.

• Disposable Income: So the greater a household’s disposable income, other things remaining the
same, the greater is its saving.

• Expected Future Income: The higher a household’s expected future income, other things remaining
the same, the smaller is its saving today.

• Wealth: The higher a household’s wealth, other things remaining the same, the smaller is its saving.

• Default Risk: The risk that a loan will not be repaid is called default risk. The greater that risk, the
higher is the interest rate needed to induce a person to lend and the smaller is the supply of loanable
funds.
 INVESTMENT
The quantity of investment goods demanded depends on the interest rate, which measures
the cost of the funds used to finance investment. For an investment project to be profitable,
its return (the revenue from increased future production of goods and services) must exceed
its cost (the payments for borrowed funds). If the interest rate rises, fewer investment projects
are profitable, and the quantity of investment goods demanded falls.

The nominal interest rate is the interest rate as usually reported: it is the rate of interest that
investors pay to borrow money. The real interest rate is the nominal interest rate corrected
for the effects of inflation. If the nominal interest rate is 8 percent and the inflation rate is 3
percent, then the real interest rate is 5 percent.
 SAVINGS
Saving is the amount of income that is not paid in taxes or spent on consumption
goods and services. Saving increases wealth. Wealth is the value of all the things
that people own. What people own is related to what they earn, but it is not the
same thing. People earn an income, which is the amount they receive during a given
time period from supplying the services of the resources they own.

The output that remains after the demands of consumers and the government have
been satisfied; it is called national saving or simply saving (S).

National saving has two components: Private saving, which is disposable income
minus consumption. The rest is public saving, which is government revenue minus
government spending. In this form, the national income accounts identity shows
that saving equals investment.
One reason investment demand might increase is technological innovation. Investment demand may also change
because the government encourages or discourages investment through the tax laws.
 GOVERNMENT SPENDING
Governments spend on guns, missiles, and the services of government employees. They also build roads and
other public works. These purchases are only one type of government spending. The other type is transfer
payments to households, such as welfare for the poor and Social Security payments for the elderly. Unlike
government purchases, transfer payments are not made in exchange for some of the economy’s output of
goods and services. Therefore, they are not included in the variable G.

We can now revise our definition of T to equal taxes minus transfer payments. Disposable income, includes
both the negative impact of taxes and the positive impact of transfer payments.

If government purchases equal taxes minus transfers, then G = T and the government has a balanced budget.
If G exceeds T, the government runs a budget deficit, which it funds by issuing government debt—that is, by
borrowing in the financial markets. If G is less than T, the government runs a budget surplus, which it can
use to repay some of its outstanding debt.
An Increase in Government Purchases

To grasp the effects of an increase in government purchases, consider the impact on the market for loanable
funds. Because the increase in government purchases is not accompanied by an increase in taxes, the government
finances the additional spending by borrowing—that is, by reducing public saving. A reduction in national saving
is represented by a leftward shift in the supply of loanable funds available for investment

The equilibrium interest rate rises to the point where the investment schedule crosses the new saving schedule.
Thus, an increase in government purchases causes the interest rate to rise
from r1 to r2.

The tendency for a government budget deficit to raise the real interest rate and decrease investment is called the
crowding-out effect.