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You are on page 1of 69

CHAPTE

R

National Income:

Where it Comes From

and Where it Goes

N. GREGORY MANKIW

PowerPoint Slides by Ron Cronovich

2007 Worth Publishers, all rights reserved

In this chapter, you will

learn

what determines the economys 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 2

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

Factors of production

K = capital:

tools, machines, and structures used in

production

L = labor:

the physical and mental efforts of

workers

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 economys level of technology

exhibits constant returns to scale

Returns to scale: A review

Initially Y1 = F (K1 , L1 )

Scale all inputs by the same factor z:

K2 = zK1 and L2 = zL1

(e.g., if z = 1.25, then all inputs are increased by 25%)

If constant returns to scale, Y2 = zY1

If increasing returns to scale, Y2 > zY1

If decreasing returns to scale, Y2 < zY1

CHAPTER 3 National Income slide 6

Example 1

F (K , L) KL

F (zK , zL) (zK )(zL)

z 2KL

z 2 KL

z KL

constant returns to

z F (K , L)

scale for any z > 0

CHAPTER 3 National Income slide 7

Example 2

F (K , L) K L

F (zK , zL) zK zL

z K z L

z K L

decreasing

z F (K , L) returns to scale

for any z > 1

Example 3

F (K , L) K 2 L2

z 2 K 2 L2

increasing returns

z F (K , L)

2

to scale for any

z>1

Now you try

increasing returns to scale for each of these

production functions:

K2

(a) F (K , L)

L

(b) F (K , L) K L

Answer to part (a)

2

K

F (K , L)

L

(zK )2

F (zK , zL)

zL

z 2K 2

zL

K2

z

L

constant returns to

z F (K , L)

scale for any z > 0

CHAPTER 3 National Income slide 11

Answer to part (b)

F (K , L) K L

F (zK , zL) zK zL

z (K L)

z F (K , L) constant returns to

scale for any z > 0

Assumptions of the model

1. Technology is fixed.

are fixed at

K K and LL

Determining GDP

and the fixed state of technology:

Y F (K , L)

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

Notation

WW ==nominal

nominalwage

wage

RR ==nominal

nominalrental

rentalrate

rate

PP ==price

priceofofoutput

output

W

W/P/P ==real

realwage

wage

(measured

(measuredininunits

unitsofofoutput)

output)

RR/P

/P ==real

realrental

rentalrate

rate

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?

Demand for labor

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

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)

Exercise: Compute & graph

MPL

a. Determine MPL at each L Y MPL

value of L. 0 0 n.a.

1 10 ?

b. Graph the production 2 19 ?

function. 3 27 8

c. Graph the MPL curve with 4 34 ?

MPL on the vertical axis 5 40 ?

and 6 45 ?

L on the horizontal axis. 7 49 ?

8 52 ?

9 54 ?

10 55 ?

CHAPTER 3 National Income slide 20

Answers:

12

60

Output (Y)

10

50

8

40

6

30

20 4

10 2

0 0

0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10

Labor (L) Labor (L)

MPL and the production function

Y

output

F (K , L)

MP

1 L As more labor

MP is added, MPL

1 L

Slope of the

MP

L production function

equals MPL

1

L

labo

CHAPTER 3 National Income r slide 22

Diminishing marginal returns

its marginal product falls (other things equal).

Intuition:

Suppose L while holding K fixed

fewer machines per worker

lower worker productivity

Check your understanding:

diminishing marginal returns to labor?

a) F (K , L) 2K 15L

b) F (K , L) KL

c) F (K , L) 2 K 15 L

Exercise (part 2) L Y MPL

0 0 n.a.

Suppose W/P = 6. 1 10 10

2 19 9

d. If L = 3, should firm hire more

3 27 8

or less labor? Why?

4 34 7

e. If L = 7, should firm hire more 5 40 6

or less labor? Why?

6 45 5

7 49 4

8 52 3

9 54 2

10 55 1

CHAPTER 3 National Income slide 25

MPL and the demand for labor

Units of

output Each

Eachfirm

firm hires

hires labor

labor

up

upto

tothe

thepoint

pointwhere

where

MPL

MPL== W/P.

W/P.

Real

wage

MPL,

Labor

demand

Units of labor, L

Quantity of labor

demanded

The equilibrium real wage

Units of Labor

output The

Thereal

realwage

wage

supply

adjusts

adjuststo

toequate

equate

labor

labor demand

demand

with

withsupply.

supply.

equilibrium

real wage MPL,

Labor

demand

L Units of labor, L

Determining the rental rate

We have just seen that MPL = W/P.

diminishing returns to capital: MPK as K

The MPK curve is the firms demand curve

for renting capital.

Firms maximize profits by choosing K

such that MPK = R/P .

The equilibrium real rental rate

Units of

Supply of The

output Thereal

realrental

rentalrate

rate

capital adjusts

adjuststo

to equate

equate

demand

demandfor forcapital

capital

with

withsupply.

supply.

equilibrium

R/P MPK,

demand for

capital

K Units of capital, K

The Neoclassical Theory

of Distribution

states that each factor input is paid its marginal

product

is accepted by most economists

How income is distributed:

W

total labor income = L MPL L

P

R

total capital income = K MPK K

P

If production function has constant returns to

scale, then

Y MPL L MPK K

income income income

The ratio of labor income to total

income in the U.S.

Labors

share

of total

income

Labors

Labors share

share of

of income

income

is

is approximately

approximately constant

constant over

over time.

time.

(Hence,

(Hence, capitals

capitals share

share is,

is, too.)

too.)

The Cobb-Douglas Production

Function

The Cobb-Douglas production function has

constant factor shares:

= capitals share of total income:

capital income = MPK x K = Y

labor income = MPL x L = (1 )Y

The Cobb-Douglas production function is:

Y AK L1

where A represents the level of technology.

CHAPTER 3 National Income slide 33

The Cobb-Douglas Production

Function

Each factors marginal product is proportional to

its average product:

Y

1 1

MPK AK L

K

(1 )Y

MPL (1 ) AK L

L

Outline of model

A closed economy, market-clearing model

Supply side

DONE factor markets (supply, demand, price)

Demand side

Next determinants of C, I, and G

Equilibrium

goods market

loanable funds market

Demand for goods & services

C = consumer demand for g & s

I = demand for investment goods

G = government demand for g & s

(closed economy: no NX )

Consumption, C

total taxes: Y T.

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.

The consumption function

C

C (Y T )

MPC

consumption function

1 is the MPC.

YT

Investment, I

where r denotes the real interest rate,

the nominal interest rate corrected for inflation.

The real interest rate is

the cost of borrowing

the opportunity cost of using ones own

funds to finance investment spending.

So, r I

The investment function

r

Spending on

investment goods

depends negatively on

the real interest rate.

I

(r )

I

Government spending, G

G excludes transfer payments

(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: C (Y T ) I (r ) G

Aggregate supply: Y F (K , L)

Equilibrium: Y = C (Y T ) I (r ) G

to equate demand with supply.

The loanable funds market

system.

One asset: loanable funds

demand for funds: investment

supply of funds: saving

price of funds: 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

r

The

The investment

investment

curve

curve is

is also

also the

the

demand

demand curve

curve for

for

loanable

loanable funds.

funds.

I

(r )

I

Supply of funds: Saving

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 the tax revenue it

receives.

Types of saving

private saving = (Y T ) C

public saving = T G

national saving, S

= private saving + public saving

= (Y T ) C + TG

= Y C G

Notation: = change in a

variable

For any variable X, X = the change in X

is the Greek (uppercase) letter Delta

Examples:

If L = 1 and K = 0, then Y = MPL.

Y

More generally, if K = 0, then MPL .

L

(YT ) = Y T , so

C = MPC (Y T )

= MPC Y MPC T

CHAPTER 3 National Income slide 48

EXERCISE:

Calculate the change in saving

For each of the following, compute S :

a. G = 100

b. T = 100

c. Y = 100

d. L = 10

Answers

S Y C G Y 0.8(Y T ) G

0.2 Y 0.8 T G

a. S 100

b. S 0.8 100 80

c. S 0.2 100 20

d. Y MPL L 20 10 200,

S 0.2 Y 0.2 200 40.

CHAPTER 3 National Income slide 50

digression:

Budget surpluses and deficits

If T > G, budget surplus = (T G )

= public saving.

If T < G, budget deficit = (G T )

and public saving is negative.

If T = G , balanced budget, public saving = 0.

The U.S. government finances its deficit by

issuing Treasury bonds i.e., borrowing.

U.S. Federal Government

Surplus/Deficit, 1940-2004

U.S. Federal Government Debt,

1940-2004

Fact:

Fact: InIn the

the early

early 1990s,

1990s,

about

about 18

18 cents

cents ofof every

every tax

tax

dollar

dollar went

went to to pay

pay interest

interest on

on

the

the debt.

debt.

(Today

(Today its

its about

about 99 cents.)

cents.)

Loanable funds supply curve

r S Y C (Y T ) G

National

National saving

saving

does

does not

not

depend

depend on on r,

r,

so

so the

the supply

supply

curve

curve is

is vertical.

vertical.

S, I

Loanable funds market

equilibrium

r S Y C (Y T ) G

Equilibrium real

interest rate

I (r )

Equilibrium level S, I

of investment

The special role of r

rr adjusts

adjusts to

to equilibrate

equilibrate the

the goods

goods market

market and

and the

the

loanable

loanable funds

funds market

market simultaneously:

simultaneously:

IfIf L.F.

L.F.market

market in

in equilibrium,

equilibrium, then

then

YY C

C G

G == II

Add

Add (C

(C +G

+G )) to

to both

both sides

sides to

to get

get

YY == C

C ++ II ++ G

G (goods

(goods market

market eqm)

eqm)

Thus,

Thus,

Eqm in L.F.

market Eqm in goods

market

Digression: Mastering

models

To master a model, 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.

CHAPTER 3 National Income slide 57

Mastering the loanable funds

model

Things that shift the saving curve

public saving

fiscal policy: changes in G or T

private saving

preferences

tax laws that affect saving

401(k)

IRA

replace income tax with consumption tax

CASE STUDY:

The Reagan deficits

Reagan policies during early 1980s:

increases in defense spending: G > 0

big tax cuts: T < 0

Both policies reduce national saving:

S Y C (Y T ) G

G S T C S

CASE STUDY:

The Reagan deficits

1.

1. The

The increase

increase in

in r S1

S2

the

the deficit

deficit

reduces

reduces saving

saving

r2

2.

2. which

which causes

causes

the

the real

real interest

interest r1

rate

rate to

to rise

rise

3.

3. which

which reduces

reduces I (r )

the

the level

level of

of I2 I1 S, I

investment.

investment.

CHAPTER 3 National Income slide 60

Are the data consistent with these

results?

TG 2.2 3.9

S 19.6 17.4

r 1.1 6.3

I 19.9 19.4

All figures are averages over the decade shown.

Now you try

Suppose the tax laws are altered to provide more

incentives for private saving.

(Assume that total tax revenue T does not change)

What happens to the interest rate and investment?

Mastering the loanable funds

model, continued

Things that shift the investment curve

some technological innovations

to take advantage of the innovation,

firms must buy new investment goods

tax laws that affect investment

investment tax credit

An increase in investment

demand

r S

interest rate. r2 in desired

investment

r1

But the equilibrium

level of investment I2

cannot increase I1

because the

S, I

supply of loanable

funds is fixed.

CHAPTER 3 National Income slide 64

Saving and the interest rate

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

r S (r )

An

An increase

increase in in

investment

investment demand

demand

raises

raises r,r,

which

which induces

induces an an r2

increase

increase in in the

the r1

quantity

quantity of of saving,

saving,

which allows II

which allows

to

to increase.

increase. I(r)2

I(r)

I1 I2 S, I

Chapter Summary

the economys quantities of capital and labor

the level of technology

Competitive firms hire each factor until its

marginal product equals its price.

If the production function has constant returns to

scale, then labor income plus capital income

equals total income (output).

Chapter Summary

consumption

investment

government spending

The real interest rate adjusts to equate

the demand for and supply of

goods and services

loanable funds

Chapter Summary

rate to rise and investment to fall.

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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