National Income:

Where it Comes From & Where it Goes

Abhisek Sur
Eco-II : Module 2

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 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
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 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

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 The Neoclassical Theory
of Distribution

▪ states that each factor input is

paid its marginal product
▪ accepted by most economists

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 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

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 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 )

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 Consumption, C
▪ Definition: disposable income is total income
minus total taxes: Y – T
▪ Consumption function: C = C (Y – T )
Shows that (Y – T )  C
▪ def: The marginal propensity to consume is the
increase in C caused by a one-unit increase in
disposable income.

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 The consumption function
C

C (Y –T )

The slope of the

MPC
consumption function
1 is the MPC.

Y–T

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 Investment, I
▪ The investment function is I = I (r ),
where r denotes the real interest rate, i.e.
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, r  I

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 The investment function
r
Spending on
investment goods
is a downward-sloping
function of the real
interest rate

I (r )

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 Government spending, G
▪ G includes government spending on goods
and services.
▪ G excludes transfer payments
▪ Assume government spending and total
taxes are exogenous:

G =G and T =T

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 The market for goods & services

• Agg. demand: C (Y − T ) + I (r ) + G

• Agg. supply: Y = F (K , L )

• Equilibrium: Y = C (Y − T ) + I (r ) + G

The real interest rate adjusts

to equate demand with supply.

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 The loanable funds market
A simple supply-demand model of
the financial system.

One asset: “loanable funds”

demand for funds: investment
supply of funds: saving
“price” of funds: real interest rate

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 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 (the cost of borrowing).

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 Loanable funds demand curve
r
The investment curve is
also the demand curve
for loanable funds.

I (r )

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 Supply of funds: Saving
The supply of loanable funds comes from
saving:
• Households use their saving to make bank
deposits, purchase bonds and other assets.
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 of the tax
revenue it receives.

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 Types of saving
▪ private saving = (Y –T ) – C

▪ public saving = T –G

▪ national saving, S
= private saving + public saving
= (Y –T ) – C + T – G
= Y – C – G

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 Digression:
Budget surpluses and deficits
• When T > G ,
budget surplus = (T – G ) = public saving

• When T < G ,
budget deficit = (G –T )
and public saving is negative.

• When T = G ,
budget is balanced and public saving = 0.

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 Government Debt & Deficits

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 Government Debt & Deficits

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 Government Debt & Deficits

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 Loanable funds supply curve
r S = Y − C (Y − T ) − G

National saving
does not
depend on r,
so the supply
curve is
vertical.

S, I

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 Loanable funds market equilibrium
r S = Y − C (Y − T ) − G

Equilibrium real
interest rate

I (r )
Equilibrium level S, I
of investment

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 The special role of r
r adjusts to equilibrate the goods market and the
loanable funds market simultaneously:
If L.F. market in equilibrium, then
Y–C–G =I
Add (C +G ) to both sides to get
Y = C + I + G (goods market eq’m)
Thus,
Eq’m in
L.F. market  Eq’m in goods
market

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Digression: mastering models
To learn a model well, be sure to know:
1. Which of its variables are endogenous and
which are exogenous.
2. For each curve in the diagram, know
a. definition
b. intuition for slope
c. all the things that can shift the curve
3. Use the model to analyze the effects of
each item in 2c .

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 Mastering the loanable funds model
1. Things that shift the saving curve

• public saving
• fiscal policy: changes in G or T

• private saving
• preferences
• tax laws that affect saving

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 Mastering the loanable funds model
2. Things that shift the investment curve
• certain technological innovations
• to take advantage of the innovation,
firms must buy new investment goods

• tax laws that affect investment

• investment tax credit

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 An increase in investment demand
r S
An increase
…raises the in desired
interest rate. r2 investment…

r1
But the equilibrium
level of investment I2
cannot increase I1
because the
supply of loanable
S, I
funds is fixed.
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 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?

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 An increase in investment demand when saving
depends on the interest rate
Real interest rate, r
S(r)

1. An increase
in desired
2. ... raises B investment. ..
the intere st
rate. . A I2

3. ... and raises I1

equilibrium investment
and saving.

Investme nt, Saving, I, S

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 Chapter summary
1. Total output is determined by
▪ how much capital and labor the economy has
▪ the level of technology

2. Competitive firms hire each factor until its marginal

product equals its price.
3. If the production function has constant returns to
scale, then labor income plus capital income equals
total income (output).

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 Chapter summary
4. The economy’s output is used for
▪ consumption
(which depends on disposable income)
▪ investment
(depends on the real interest rate)
▪ government spending
(exogenous)
5. The real interest rate adjusts to equate
the demand for and supply of
▪ goods and services
▪ loanable funds

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 Chapter summary
6. A decrease in national saving causes the
interest rate to rise and investment to fall.
7. An increase in investment demand causes
the interest rate to rise, but does not affect
the equilibrium level of investment
if the supply of loanable funds is fixed.

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 GDP & Welfare

▪ What are the benefits ?

▪ Is GDP a true measure of Welfare?

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The Uses and Limitations of Real GDP
▪ We use real GDP to calculate the economic growth rate

▪ The economic growth rate is the percentage change in the quantity

of goods and services produced from one year to the next.

▪ We measure economic growth so we can make:

▪ Economic welfare comparisons across time
▪ International comparisons across countries
▪ Business cycle forecasts

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The Uses and Limitations of Real GDP
▪ Real GDP is not a perfect measure of
economic welfare for eight reasons:
1. Inflation rate tends to be overestimated because quality
improvements are neglected, so real GDP is underestimated.
2. Real GDP does not include household production -productive
activities done in and around the house by members of the
household.
3. Real GDP, as measured, omits the underground economy, which is
illegal economic activity or legal economic activity that goes
unreported for tax avoidance reasons.
In some developing countries, more than half the workers may be in the underground economy. A
large informal sector can be a sign of government policies that are retarding economic growth.
Read this: “The Rise of the Underground”
http://online.wsj.com/article/SB123698646833925567.html

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The Uses and Limitations of Real GDP
4. Health and life expectancy are not
directly included in real GDP

5. GDP Measures the Size of the Pie but

Not
How the Pie Is Divided Up

6. Leisure time, a valuable component of an

individual’s welfare is not included in real GDP

7. Environmental damage is not deducted from real GDP.

8. Political freedom and social justice are not included in real GDP.

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The Uses and Limitations of Real GDP
▪ Economic Welfare Comparisons Across Countries
▪ Real GDP is used to compare economic welfare in one
country with that in another.

▪ Two special problems arise in making these comparisons.

▪ Real GDP of one country must be converted into the
same currency units as the real GDP of the other
country, so an exchange rate must be used.
▪ The same prices should be used to value the goods and
services in the countries being compared, but often are
not.

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The Uses and Limitations of Real GDP
▪ Using the exchange rate to compare GDP in one country
with GDP in another country is problematic because
prices of particular products in one country may be
much less or much more than in the other country.

▪ For example, using the market exchange rate to value

Chinese GDP in dollars leads to an estimate that in 2006,
U.S. real GDP per person was 28 times Chinese real GDP
per person.

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 Alternate Metrics
▪ The HDI (Human Development Index), for instance, tries to
bring in issues like literacy, infant mortality, life expectancy,
etc. From 2010 , HDR introduced the Inequality-Adjusted HDI
(IHDI), which takes into account inequality in all three
dimensions of the HDI by ‘discounting’ each dimension’s
average value according to its level of inequality.

▪ The Gross National Happiness Index is developed by the

government of Bhutan in 1972. It is an index that includes
various parameters of social existence other than GDP. This
measure uses elaborate surveys that ask how content people
feel in nine domains: psychological well-being, standard of
living, governance, health, education, community vitality,
cultural diversity, time use and ecological diversity. Similar
measure is also adopted by World Values Survey (WVS) or The
Better Life Index (OECD).
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▪
 Alternate Metrics
▪ The Happy Planet Index developed by the New Economics
Foundation in 2006 multiplies life satisfaction by life
expectancy and divides the product by a measure of ecological
impact.

▪ The GPI (Genuine Progress Indicator) is often considered as a

replacement of the GDP.
▪ Takes everything the GDP uses into account, but also adds
other figures that represent the cost of the negative effects
related to economic activity (such as the cost of crime, cost of
ozone depletion and cost of resource depletion, among others).

▪ By 2015, the UN has announced the Sustainable Development

Goals, a set of international objectives to improve global well-
being.

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