Lecture 3

National Income

1. Supply side
 factor markets (supply, demand, price)
 determination of output/income

2. Demand side
 determinants of C, I, and G
3. Equilibrium
 goods market
 loanable funds market

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 Lecture 3. National Income

A basic classical model

• the determinants of the level of output (income)

• how income is distributed
• how output is allocated among alternative uses
• what ensures that the supply of and demand for goods are
equal

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 Lecture 3. National Income

What Determines the Total Production of Goods and

Services?

• The Factors of Production

K = capital: tools, machines, and structures used in production
L = labor: the physical and mental efforts of workers

• The Production Function: Y = F(K,L)

o shows how much output (Y ) the economy can produce from K units
of capital and L units of labor
o reflects the economy’s level of technology
o exhibits constant returns to scale

• The Supply of Goods and Services

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 Lecture 3. National Income

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 = 1.2, then all inputs are increased by 20%)
What happens to output, Y2 = F (K2, L2 )?
• If constant returns to scale, Y2 = zY1
• If increasing returns to scale, Y2 > zY1
• If decreasing returns to scale, Y2 < zY1
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 Lecture 3. National Income

Output (Y) Production function

Y =F (K,L)

0 Capital (K) 5
 Lecture 3. National Income

Slope. Marginal product of capital (>0)

Output-labour
ratio
(y=Y/L)
y =f (k )

 y

k

0 Capital-labour ratio
(k=K/L) 6
 Lecture 3. National Income

Curve. Diminishing marginal productivity

Output-labour
ratio
(y=Y/L)
y =f (k )
} y 2

k
 y 1
 y1  y 2
k

0 Capital-labour ratio
(k=K/L)
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 Lecture 3. National Income

Shift. Changes in productivity

Output-labour
ratio y =f2(k )
(y=Y/L)
y=f1(k )

0 Capital-labour ratio
(k=K/L) 8
 Lecture 3. National Income

The Distribution of National Income to the

Factors of Production

• Factor Prices
• The Decisions Facing the Competitive Firm
• The Firm’s Demand for Factors
• The Division of National Income

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Lecture 3. National Income

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Lecture 3. National Income

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Lecture 3. National Income

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 Lecture 3. National Income

Production Function: Y=f(K,L)

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 Lecture 3. National Income

The Cobb–Douglas Production Function

• 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 is:
 1
Y  AK L
where A represents the level of technology.

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 Lecture 3. National Income

Demand for Goods and Services

• Consumption

• Investment

• Government Purchases

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 Lecture 3. National Income

The Consumption Function

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 Lecture 3. National Income

The Investment Function

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 Lecture 3. National Income

What Brings the Supply and Demand for

Goods and Services Into Equilibrium?

• Equilibrium in the Market for Goods and Services

o Demand for g&s
o Supply of g&s

• Equilibrium in the Financial Markets

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 Lecture 3. National Income

Saving, Investment, and the Interest Rate

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 Lecture 3. National Income

A Reduction in Saving

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 Lecture 3. National Income

Wars and Interest Rates in the UK

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 Lecture 3. National Income

An Increase in the Demand for Investment

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 Lecture 3. National Income

An Increase in Investment Demand When

Saving Depends on the Interest Rate

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 Supply & Demand in
Macroeconomics
• Aggregate demand curve
– Quantity of domestic product – demanded
– Each possible value of price level
• Aggregate supply curve
– Quantity of domestic product – supplied
– Each possible value of price level

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 Figure 1.1
Two interpretations of a shift in the demand curve
D1
S S
Price

Price
D D0
A
P1
E E
P0 P0

S S
D1
D D0
0 Q0 0

Quantity Quantity

(a) (b) 25
 Supply & Demand in
Macroeconomics
• Inflation
– Sustained increase in price level
– Outward shift of aggregate demand curve
• Recession – period of time
– Total output – declines
• Production falls
• People lose jobs
– Leftward shift of aggregate demand curve

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 Figure 1.2
An economy slipping into a recession
D0 S

D2
E
Price Level

P0
B
P2

S D0
D2
0 Q2 Q0

Domestic Product
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 Supply & Demand in
Macroeconomics
• Macroeconomists study these
major economic issues
– Inflation
– Recession & unemployment
– Economic growth
The main instruments of Macro
Economic Policy
• Fiscal Policy
– Fiscal policy involves the use of government
spending, taxation and borrowing to influence
both the pattern of economic activity and also
the level and growth of aggregate demand,
output and employment.
• Monetary Policy
– Monetary policy involves the use of interest
rates to control the level and rate of growth of
aggregate demand in the economy.