Transcript Topic 2: National Income

BUS 530: ECONOMIC CONDITIONS
ANALYSIS
LECTURE: 2
Classical Theory: The Economy in
the Long Run
National Income:
Introduction
• How an economy’s total output/income is
produced
• How the prices of the factors of production
are determined
• How total income is distributed
• What determines the demand for goods and
services (how is total income spent?)
• How equilibrium in the goods market is
achieved
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Outline of Model
A closed economy, market-clearing model
Economic Agents
• Households
• Firms
• Government
Markets where these agents interact
• Market for Goods and Services
• Factor Markets
• Financial Markets
The interaction between agents in the context of markets
determines an economy’s resource allocation and
progress
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The Circular Flow of Money Through the Economy
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Who Produces Output?
Factors of Production
K =
capital:
tools, machines, and structures used in
production
L =
labor:
the physical and mental efforts of workers
AND
TECHNOLOGY
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The Production Function
• denoted by Y = F(K,L)
• shows how much output (Y) the economy
can produce by using 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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Returns to Scale: A review
Initially Y1 = F (K1 , L1 )
Suppose all inputs were to increase by the same factor z:
K2 = zK1 and L2 = zL1
(e.g., if z = 2, then all inputs are doubled)
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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Assumptions of the Model
1. Technology is fixed.
2. The economy’s supplies of capital and labor are
fixed at
K K
and
LL
Why? Because we are looking at the “long run” where
all resources are fully utilized or employed
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Determining GDP
Output is determined by the fixed factor supplies
and the fixed state of technology:
Y  F (K , L)
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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
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Notation
W
R
P
W /P
= nominal wage
= nominal rental rate
= price of output
= real wage
(measured in units of output)
R /P = real rental rate
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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?
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Demand for Labor
• Assume markets are competitive:
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
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Marginal Product of Labor (MPL)
• Definition:
The extra output the firm can produce
using an additional unit of labor
(holding all other inputs fixed):
MPL = F(K,L+1) – F(K,L)
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MPL and the Production Function
Y
output
F (K , L )
MPL
1
As more labor is
added, MPL 
MPL
1
MPL
1
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Slope of the production
function equals MPL
L
labor
Diminishing Marginal Returns
• As a factor input is increased,
its marginal product falls (other things
equal).
• Intuition:
Suppose L while holding K fixed
 fewer machines per worker
 lower worker productivity
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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
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The Equilibrium Real Wage
Units of
output
Labor
supply
equilibrium
real wage
MPL, Labor
demand
L
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The real wage
adjusts to equate
labor demand with
supply.
Units of labor, L
Determining the Rental Rate
We have just seen that MPL = W/P.
The same logic shows that MPK = R/P :
• diminishing returns to capital: MPK  as K 
• The MPK curve is the firm’s demand curve
for renting capital.
• Firms maximize profits by choosing K
such that MPK = R/P .
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The Equilibrium Real Rental Rate
Units of
output
Supply of
capital
equilibrium
R/P
MPK, demand
for capital
K
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The real rental rate
adjusts to equate
demand for capital
with supply.
Units of capital, K
The Cobb-Douglas Production
Function
• The Cobb-Douglas production function is:

1
Y  AK L
where A represents the level of technology
• 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
• .
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The Cobb-Douglas Production
Function
• Each factor’s marginal product is
proportional to its average product:
MPK   AK
 1 1
L

Y
K
(1   )Y
 
MPL  (1   ) AK L 
L
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How Income is Distributed:
total labor income = MPL  L  (1   )Y
total capital income =
MPK  K  Y
If production function has constant returns to
scale, then
Y  MPL  L  MPK  K
national
income
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labor
income
capital
income
Empirical Estimates of the CobbDouglas Production Function
• Economists have estimated that the share of capital
income in U.S. GDP is approximately 33%, .i.e.  =
0.33
• Labor’s share in U.S. GDP is approximately 67%.
• These shares are roughly constant over long periods
of time: fits the Cobb-Douglas Specification.
Y  AK
1/ 3
2/3
L
National
Income
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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
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0
1960
National
1970
1980
1990
2000
The Neoclassical Theory
of Distribution
• Each factor of production is paid its marginal
product
• In equilibrium, MPL = W/P (real wage)
MPK = r/P (real rental rate)
• Characterized by the Law of Diminishing Returns
• Growth in factor productivity should be tracked by
the growth in real factor income.
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Income
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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
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Demand for Goods & Services
Components of Aggregate Demand:
C = consumer demand for goods & services
I = firms’ demand for investment goods
G = government demand for goods & services
(closed economy: No Exports or Imports )
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Gross Domestic Product, USA
[Billions of dollars]
Seasonally adjusted at annual rates
Source: Bureau of Economic Analysis
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Gross Domestic Product, Bangladesh
[
In BDT crore
2009-2010
2010-2011
Total Consumption
554771
633215
Total Investment
169511
194786
Total Expenditure
201124
211516
Net Exports
-62093
-95596
Source: Bangladesh Bank and Budget
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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
• Definition: Marginal propensity to
consume (MPC) 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)
MPC
1
The slope of the
consumption function
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,
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
depends negatively on
the real interest rate.
I (r )
I
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Government Spending, G
• G = govt spending on goods and services.
• Assume government spending and total
taxes are exogenous:
G G
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and
T T
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.
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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
(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 )
I
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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 the tax revenue it
receives.
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Types of Saving
private saving
SP = (Y – T) – C
public saving
Sg = T – G
national saving, S = SP + Sg
= private saving + public saving
= (Y –T ) – C + T – G
=
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Y – C – G
National
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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Equilibrium in The Financial Market
We may rewrite the national income identity as
Y - C- G = I
S=I
By splitting Savings into private saving and public
Saving
S = (Y-T-C) +(T-G) = I
To see how the interest rate brings financial market
Equilibrium, substitute the consumption function
Into the national income identity
Y – C(Y-T) – G = I(r)
Equilibrium in The Financial Market
Note that G, T are fixed by policy and Y by factors
of production and the production function:
S  Y  C (Y  T )  G
Loanable Funds Market
Equilibrium
r
S  Y  C (Y  T )  G
Equilibrium real
interest rate
I (r )
Equilibrium level
of investment
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S, I
Changes in Saving: The Effects of Fiscal
Policy
An increase in Government purchases ΔG.
•Total output Y is fixed by factors of production and
Technology. Since taxes are unchanged, disposable
Income Y-T and thereby C is also unchanged.
Therefore, the increase in government purchase
must be met by an equal decrease in investment.
•Public saving is reduced, because T is unchanged
A Reduction in Saving
r₂
r₁
Class Exercise
Analyze the impact of a decrease in taxes ΔT
Changes in Investment Demand
Investment demand may change:
(i)because of advent of a new technology
(ii)Encouragement or discouragement of investment
through the tax laws, e.g. tax cuts
Surprising implication of the model is that the
equilibrium amount of investment must remain
unchanged. Merely raises the equilibrium interest
rate.
What if consumption (and its flip side savings) were
To depend on the interest rate?
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.
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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
– Tax exemption of Sanchaypatra
– replace income tax with consumption tax
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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
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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.
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I1
I2
S, I
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 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
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S, I
Chapter Summary
• Total output is determined by
– the economy’s 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).
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Chapter Summary
• A closed economy’s output is used for
– consumption
– investment
– government spending
• The real interest rate adjusts to equate
the demand for and supply of
– goods and services
– loanable funds
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Chapter Summary
• A decrease in national saving causes the
interest 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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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.
• Governments’ finance their deficits by
issuing Treasury bonds – i.e., borrowing.
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U.S. Federal Government Surplus/Deficit,
1940-2004
5%
0%
(% of GDP)
-5%
-10%
-15%
-20%
-25%
-30%
1940
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1950
1960
1970
1980
1990
2000
Bangladesh Budget Deficit (% of GDP)
U.S. Federal Government Debt,
1940-2004
120%
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.)
(% of GDP)
100%
80%
60%
40%
20%
0%
1940
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1950
National
1960
1970
1980
1990
2000
Bangladesh Government Debt(%of
GDP)
The U.S. Budget Deficit: Where is it
Headed?
2002
Actual or
Projected
(USD,
billions)
U.S. Budget Deficits
450
400
350
157
2004
412
2006
248
2007
158*
300
USD,bn
Year
250
Series1
200
150
2008
244*
100
50
2011
400*
0
2002
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2004
2006
2007
2008
2011
"Over the long term, the budget remains on an
unsustainable path"
-Congressional Budget Office Report, 2007
• Continued military operations in Iraq and
Afghanistan
• Extension of temporary tax cuts enacted in
President Bush's first term
• Rising health-care and social security costs
and the retirement of the “baby-boom”
generation
• Longer-term outlook is bleak.
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The special role of r
r adjusts to equilibrate the goods market and the
loanable funds market simultaneously:
If Loanable Funds market is in equilibrium, then
Y–C–G =I
Y = C + I + G (goods market eq’m)
Thus,
Eq’m in L.F.
market
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
Eq’m in goods
market
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
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T   C   S
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.
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r
S2
S1
r2
r1
I (r )
I2
I1
S, I
Are the data consistent with these results?
variable
T–G
S
r
I
1970s
–2.2
19.6
1.1
19.9
1980s
–3.9
17.4
6.3
19.4
T–G, S, and I are expressed as a percent of GDP
All figures are averages over the decade shown.
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Military Spending and the Interest Rate in the
United Kingdom: 1730-1920
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The Neoclassical Theory in Action…
•
•
•
•
Black Death and Factor Prices
Outbreak of bubonic plague in Europe or
The Black Death in the year 1348
The population of Europe was reduced by
a third
Real wages doubled and peasants enjoyed
economic prosperity
Real rents on land fell by nearly 50 percent
and the landowner class suffered
significant reductions in their incomes
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The Neoclassical Theory in Action…
The Abolition of Slavery Act, U.K. (1833)
• Former slaves in the Caribbean colonies
demanded higher wages and compensation
• Plantations in the Caribbean Islands became
less profitable as labor costs rose
• British response: IMPORT labor from
colonies in Asia and Africa
• What happened to wage rates in the
Caribbean?
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Bangladesh Growth Rate of Labor Productivity
Yearly rate of growth Yearly rate of growth
(%)1991-2005
(%) 1991-2001
Growth rate of Labor
Productivity
3.10%
5.10%
Sources: BBS, Census of Manufacturing Industries
Bangladesh Growth Rate of Real Wages
Base:1996
Year
Change (%)
over previous survey
1996
2000
2006
14.12 (in 4 years)
14.96 (in 6 years)
Sources: Labor Force Survey Data (various years)
Chapter Summary
Money
– the stock of assets used for transactions
– serves as a medium of exchange, store of value, and unit
of account.
– Commodity money has intrinsic value, fiat money does
not.
– Central bank controls the money supply.
Quantity theory of money assumes velocity is stable,
concludes that the money growth rate determines the
inflation rate.
CHAPTER 4
Money and Inflation
slide 82
Chapter Summary
Nominal interest rate
– equals real interest rate + inflation rate
– the opp. cost of holding money
– Fisher effect: Nominal interest rate moves
one-for-one w/ expected inflation.
Money demand
– depends only on income in the Quantity Theory
– also depends on the nominal interest rate
– if so, then changes in expected inflation affect the
current price level.
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Money and Inflation
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Chapter Summary
Costs of inflation
– Expected inflation
shoeleather costs, menu costs,
tax & relative price distortions,
inconvenience of correcting figures for inflation
– Unexpected inflation
all of the above plus arbitrary redistributions of wealth
between debtors and creditors
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Money and Inflation
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Chapter Summary
Hyperinflation
– caused by rapid money supply growth when money
printed to finance govt budget deficits
– stopping it requires fiscal reforms to eliminate
govt’s need for printing money
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Money and Inflation
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Chapter Summary
Classical dichotomy
– In classical theory, money is neutral--does not affect real
variables.
– So, we can study how real variables are determined w/o
reference to nominal ones.
– Then, money market eq’m determines price level and all
nominal variables.
– Most economists believe the economy works this way in
the long run.
CHAPTER 4
Money and Inflation
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