MACROECONOMICS

N. Gregory Mankiw

PowerPoint ® Slides by Ron Cronovich C H A P T E R 3

National Income: Where it Comes From and Where it Goes

© 2011 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

Factors of production

K

= capital: tools, machines, and structures used in production

L

= labor: the physical and mental efforts of workers

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National Income 2

The production function: Y = F(K,L)

 Shows how much output (

Y

) the economy can produce from

K

units of capital and

L

units of labor

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National Income 3

Assumptions

1.

The economy’s supplies of capital and labor are fixed at

K



K

and

L



L

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National Income 4

Determining GDP

Output is determined by the fixed factor supplies and the fixed state of technology:

Y



( ) CHAPTER 3

National Income 5

The distribution of national income

 Determined by

factor prices

, the prices per unit firms pay for the factors of production  wage = price of

L



ren tal rate

= price of

K

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National Income 6

Notation

W R

= nominal wage = nominal rental rate

P

= price of output

W

/

P

= real wage (measured in units of output)

R

/

P

= real rental rate

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National Income 7

In 2011 January

 Nominal wage = $20 per hour  Price of the good = $4 per unit produced  Real wage = (Nominal Wage / Price ) = $20 / $4 = 5 units of goods.

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National Income 8

In 2012 January

 Nominal wage = $20 per hour  Price of the good = $5 per unit produced  Real wage = (Nominal Wage / Price ) = $20 / $5 = 4 units of goods.

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National Income 9

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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National Income 10

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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National Income 11

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

)

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National Income 12

NOW YOU TRY: Compute & graph MPL a.

Determine

MPL

at each value of

L.

b.

Graph the production function.

c.

Graph the

MPL

curve with

MPL

on the vertical axis and

L

on the horizontal axis.

7 8 9 10

L

0 1 2 3 4 5 6

Y

0 10 19 27 34 40 45 49 52 54 55

MPL

n.a.

?

?

8 ?

?

?

?

?

?

?

NOW YOU TRY: Answers Marginal Product of Labor

6 4 2 12 10 8 0 0 1 2 3 4 5 6 7 8 9

Labor (L)

10

MPL and the production function

output

Y

1 MPL

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National Income 1 MPL 1 MPL As more labor is added,

MPL

 Slope of the production function equals

MPL

labor

L

15

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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National Income 16

NOW YOU TRY: Identifying Diminishing Marginal Returns

 Which of these production functions have diminishing marginal returns to labor? a)

( , )

 2

K

 15

L

b)

F K L



KL

c)

( , )

 2

K

 15

L

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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National Income 18

The equilibrium real wage

Units of output Labor supply The real wage adjusts to equate labor demand with supply.

equilibrium real wage

L

MPL

, Labor demand Units of labor,

L

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National Income 19

Determining the rental rate

 We have just seen that

MPL

=

W

/

P

.

 The same logic shows that

MPK

  diminishing returns to capital:

MPK

The

MPK

=

R

/

P

:  as

K

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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National Income 20

The equilibrium real rental rate

Units of output Supply of capital The real rental rate adjusts to equate demand for capital with supply.

equilibrium

R/P K

MPK, demand for capital Units of capital,

K

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National Income 21

How income is distributed to L and K

total labor income = total capital income =

W L P R K P

 

MPK



K

If production function has constant returns to scale, then

Y

 

MPK



K

national income

CHAPTER 3

National Income labor income capital income 22

The ratio of labor income to total income in the U.S., 1960-2007

Labor’s share of 1,0 total income 0,8 0,6 0,4 0,2 Labor’s share of income is approximately constant over time.

(Thus, capital’s share is, too.)

CHAPTER 3

0,0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 National Income 23

The Cobb-Douglas Production Function

 The Cobb-Douglas production function is: where

A

represents the level of technology.

Y



AK L

1  

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National Income 24

 The Cobb-Douglas production function has constant factor shares:  = capital’s share of total income: capital income =

MPK

labor income =

MPL

x

K

x

L

=  = (1 –

Y

 )

Y

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National Income 25

The Cobb-Douglas Production Function

 Each factor’s marginal product is proportional to its average product:

MPK MPL

 

AK

  1

L

1    

Y

 )

AK L

  

K

(1   )

Y L

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National Income 26

Demand for goods & services

Components of aggregate demand:

C I

= consumer demand for g & s = demand for investment goods

G

= government demand for g & s (closed economy: no

NX

)

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National Income 27

Consumption, C

 def:

Disposable income

total taxes:

Y

–

T.

is total income minus  Consumption function:

C

Shows that  (

Y

–

T

)  

C

=

C

(

Y

–

T

)  def:

Marginal propensity to consume (MPC)

is the change in

C

when disposable income increases by one dollar.

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National Income 28

The consumption function

C C

(

Y

–

T

) 1

MPC

The slope of the consumption function is the

MPC

.

Y – T

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National Income 29

Investment, I

 The investment function is

I

where

r

=

I

(

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 CHAPTER 3

National Income 30

The investment function r

Spending on investment goods depends negatively on the real interest rate.

I

(

r

)

I CHAPTER 3

National Income 31

Government spending, G



G

= Gov’t spending on goods and services.  Assume government spending and total taxes are exogenous:

G



G

and

T



T

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National Income 32

The market for goods & services

 Aggregate demand: ( )  

G

 Aggregate supply:

Y

  Equilibrium:

Y

= ( )  

G CHAPTER 3

National Income 33

The loanable funds market

 A simple supply-demand model of the financial system.

 One asset: “loanable funds”    demand for funds: investment supply of funds: “price” of funds: saving real interest rate

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National Income 34

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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National Income 35

Loanable funds demand curve r

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

I

(

r

)

I CHAPTER 3

National Income 36

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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National Income 37

Types of saving private saving public saving

=

S

= (

Y

–

T

) –

C

=

T

–

G

national saving

, = private saving + public saving = (

Y

–

T

) –

C

+

T

–

G

=

Y

–

C

–

G

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National Income 38

Budget surpluses and deficits

 If

T

>

G

,

budget surplus

= (

T

–

G

) = public saving.

 If

T

<

G

,

budget deficit

= (

G

and public saving is negative. –

T

)  If

T

=

G

, “balanced budget,” public saving = 0.

 The U.S. government finances its deficit by issuing Treasury bonds –

i.e

., borrowing.

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National Income 39

U.S. Federal Government Surplus/Deficit, 1940-2009 and estimates for 2010-2015

10 -5 -10 -15 -20 5 0 -25 -30 -35 1940 1970 1980 1990 2000 2010 40

U.S. Federal Government Debt, 1940-2009 and estimates for 2010-2015

140 120 100 80 60 40 20 0 1940 1970 1980 1990 2000 2010 41

Loanable funds supply curve r

National saving does not depend on

r

, so the supply curve is vertical.

) 

G S, I CHAPTER 3

National Income 42

Loanable funds market equilibrium r

) 

G

Equilibrium real interest rate Equilibrium level of investment

CHAPTER 3

National Income

I

(

r

)

S, I

43

Read ……..

The Reagan deficits

 Reagan policies during early 1980s:

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National Income 44