Transcript National Income: Where it Comes From and Where it Goes Adapted

CHAPTER
3
National Income: Where it
Comes From and Where it Goes
Adapted for EC 204 by
Prof. Bob Murphy
MACROECONOMICS
SIXTH EDITION
N. GREGORY MANKIW
PowerPoint® Slides by Ron Cronovich
© 2007 Worth Publishers, all rights reserved
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
CHAPTER 3
National Income
slide 1
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
CHAPTER 3
National Income
slide 2
Factors of production
K = capital:
tools, machines, and structures used in
production
L = labor:
the physical and mental efforts of
workers
CHAPTER 3
National Income
slide 3
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 economy’s level of technology
 exhibits constant returns to scale
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National Income
slide 4
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%)
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
CHAPTER 3
National Income
slide 5
Assumptions of the model
Technology is fixed.
Production function has constant returns to
scale.
The economy’s supplies of capital and labor
are fixed at
K K
CHAPTER 3
and
National Income
LL
slide 12
Determining GDP
Output is determined by the fixed factor supplies
and the fixed state of technology:
Y  F (K , L)
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National Income
slide 13
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
CHAPTER 3
National Income
slide 14
Notation
W
= nominal wage
R
= nominal rental rate
P
= price of output
W /P = real wage
(measured in units of output)
R /P = real rental rate
CHAPTER 3
National Income
slide 15
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?
CHAPTER 3
National Income
slide 16
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)
Or using calculus:
MPL = ¶F(K,L) / ¶L
CHAPTER 3
National Income
slide 18
MPL and the production function
Y
output
F (K , L )
1
MPL
MPL
As more labor is
added, MPL 
1
MPL
Slope of the production
function equals MPL
1
L
labor
CHAPTER 3
National Income
slide 21
MPL and the demand for labor
Units of
output
Each firm hires labor
up to the point where
MPL = W/P.
Real
wage
MPL,
Labor
demand
Units of labor, L
Quantity of labor
demanded
CHAPTER 3
National Income
slide 25
The equilibrium real wage
Units of
output
Labor
supply
equilibrium
real wage
L
CHAPTER 3
National Income
The real wage
adjusts to equate
labor demand
with supply.
MPL,
Labor
demand
Units of labor, L
slide 26
The equilibrium real rental rate
Units of
output
Supply of
capital
equilibrium
R/P
K
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National Income
The real rental rate
adjusts to equate
demand for capital
with supply.
MPK,
demand for
capital
Units of capital, K
slide 28
How income is distributed:
W
L  MPL  L
total labor income =
P
R
K  MPK  K
total capital income =
P
If production function has constant returns to
scale, then
Y  MPL  L  MPK  K
national
income
CHAPTER 3
labor
income
National Income
capital
income
slide 30
How income is distributed:
If production function has constant returns to
scale, then zY  F(zK , zL)
Differentiate with respect to z and set z = 1:
Y  [F(zK , zL) / K]K  [F(zK, zL) / L]L
Y  MPK  K  MPL  L
Output exactly equals factor incomes.
CHAPTER 3
National Income
slide 31
The ratio of labor income to total
income in the U.S.
1
Labor’s
share
of total 0.8
income
0.6
Labor’s share of income
is approximately constant over time.
(Hence, capital’s share is, too.)
0.4
0.2
0
1960
CHAPTER 3
1970
National Income
1980
1990
2000
slide 32
Outline of model
A closed economy, market-clearing model
Supply side
DONE 
factor markets (supply, demand, price)
DONE 
determination of output/income
Demand side
Next   determinants of C, I, and G
Equilibrium
 goods market
 loanable funds market
CHAPTER 3
National Income
slide 35
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 )
CHAPTER 3
National Income
slide 36
The market for goods & services
 Aggregate demand:
C (Y  T )  I (r )  G
 Aggregate supply:
 Equilibrium:
Y  F (K , L )
Y = C (Y  T )  I (r )  G
 The real interest rate adjusts
to equate demand with supply.
CHAPTER 3
National Income
slide 42
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
CHAPTER 3
National Income
slide 43
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).
CHAPTER 3
National Income
slide 44
Loanable funds demand curve
r
The investment
curve is also the
demand curve for
loanable funds.
I (r )
I
CHAPTER 3
National Income
slide 45
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 the tax revenue it
receives.
CHAPTER 3
National Income
slide 46
Types of saving
private saving = (Y – T ) – C
public saving
=
T – G
national saving, S
= private saving + public saving
= (Y –T ) – C +
=
CHAPTER 3
T–G
Y – C – G
National Income
slide 47
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.
CHAPTER 3
National Income
slide 51
U.S. Federal Government
Surplus/Deficit, 1940-2004
5%
0%
(% of GDP)
-5%
-10%
-15%
-20%
-25%
-30%
1940
CHAPTER 3
1950
1960
National Income
1970
1980
1990
2000
slide 52
U.S. Federal Government Debt,
1940-2004
Fact: In the early 1990s,
about 18 cents of every tax
dollar went to pay interest on
the debt.
(Today it’s about 9 cents.)
120%
(% of GDP)
100%
80%
60%
40%
20%
0%
1940
CHAPTER 3
1950
1960
National Income
1970
1980
1990
2000
slide 53
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
CHAPTER 3
National Income
slide 54
Loanable funds market
equilibrium
r
S  Y  C (Y  T )  G
Equilibrium real
interest rate
I (r )
Equilibrium level
of investment
CHAPTER 3
National Income
S, I
slide 55
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,
CHAPTER 3
Eq’m in L.F.
market
National Income

Eq’m in goods
market
slide 56
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
CHAPTER 3
National Income
T   C   S
slide 59
CASE STUDY:
The Reagan deficits
1. The increase in
the deficit
reduces saving…
2. …which causes
the real interest
rate to rise…
3. …which reduces
the level of
investment.
CHAPTER 3
National Income
r
S2
S1
r2
r1
I (r )
I2
I1
S, I
slide 60
Are the data consistent with these results?
variable
1970s
1980s
T–G
–2.2
–3.9
S
19.6
17.4
r
1.1
6.3
I
19.9
19.4
T–G, S, and I are expressed as a percent of GDP
All figures are averages over the decade shown.
CHAPTER 3
National Income
slide 61
An increase in investment demand
r
…raises the
interest rate.
r2
S
An increase
in desired
investment…
r1
But the equilibrium
level of investment
cannot increase
because the
supply of loanable
funds is fixed.
CHAPTER 3
National Income
I1
I2
S, I
slide 64
An increase in investment demand
when saving depends on r
An increase in
investment demand
raises r,
which induces an
increase in the
quantity of saving,
which allows I
to increase.
r
S (r )
r2
r1
I(r)2
I(r)
I1 I2
CHAPTER 3
National Income
S, I
slide 66