macro

CHAPTER THREE

National Income:
Where it Comes From
and Where it Goes

macroeconomics
fifth edition

N. Gregory Mankiw
PowerPoint Slides
by Ron Cronovich
2003 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

CHAPTER 3

National Income

slide 3

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 4

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.

CHAPTER 3

National Income

slide 5

Returns to scale: a review

Initially Y1 = F (K1 , L1 )
Scale all inputs by the same factor z:
K2 = zK1 and L2 = zL1
(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 6

Exercise: determine returns to scale

Determine whether each of the following
production functions has constant, increasing,
or decreasing returns to scale:

(b)
2

F
K
(,)
L
KL

(a)

FKLKL
(,)

(c) 215

FKLKL
(,)
(d) 215

FKLKL
(,)

(e) 215
22

FKLKL
(,)

CHAPTER 3

National Income

slide 7

Assumptions of the model

1. Technology is fixed.
2. The economys supplies of capital
and labor are fixed at

and

CHAPTER 3

National Income

slide 8

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

CHAPTER 3

National Income

slide 9

The distribution of national income

determined by factor prices,
the prices per unit that firms pay for
the factors of production.

The wage is the price of L ,

the rental rate is the price of K.

CHAPTER 3

National Income

slide 10

Notation
W
W
RR

==nominal
nominalwage
wage
==nominal
nominalrental
rentalrate
rate

PP ==price
priceof
ofoutput
output
W
W/P
/P ==real
realwage
wage
(measured
(measuredin
inunits
unitsof
ofoutput)
output)
RR/P
/P ==real
realrental
rentalrate
rate

CHAPTER 3

National Income

slide 11

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 12

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
labor

CHAPTER 3

= marginal product of

National Income

slide 13

Marginal product of labor (MPL)

def:
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)

CHAPTER 3

National Income

slide 14

Exercise: 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
CHAPTER 3

National Income

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

Y MPL
0 n.a.
10
?
19
?
27
8
34
?
40
?
45
?
49
?
52
?
54
?
55
?
slide 15

answers:
Marginal Product of Labor

Production function

12

60

10

50
40
Output

(Y)

6
(units of output)
4

30
20

MPL

10

0
0

9 10

Labor (L)

CHAPTER 3

National Income

9 10

Labor (L)

slide 16

The MPL and the production

function
Y
output

(,)
FKL

MP
1 L

As more labor
is added, MPL

MP
1 L
MP
L
1

CHAPTER 3

Slope of the
production function
equals MPL

National Income

L
labo
r

slide 17

Diminishing marginal returns

As a factor input is increased, its
marginal product falls (other things
equal).

Intuition:
L while holding K fixed
fewer machines per worker
lower productivity

CHAPTER 3

National Income

slide 18

Check your understanding:

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

a) 215

FKLKL

FKLKL
b)
c) 215

FKLKL

CHAPTER 3

National Income

slide 19

Exercise (part 2)
Suppose W/P = 6.

d. If L = 3, should firm hire

more or less labor? Why?

e. If L = 7, should firm hire

more or less labor? Why?

CHAPTER 3

National Income

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

Y MPL
0 n.a.
10
10
19
9
27
8
34
7
40
6
45
5
49
4
52
3
54
2
55
1
slide 20

MPL and the demand for labor

Units of
output

Each
Each firm
firm hires
hires
labor
labor
up
up to
to the
the point
point
where
where MPL
MPL =
= W/P
W/P

Real
wag
e

Quantity of
labor
demanded
CHAPTER 3

National Income

MPL,
Labor
demand
Units of labor,
L

slide 21

The equilibrium real wage

Units of
output

equilibriu
m real
wage

Labor
supply

MPL,
Labor
demand
Units of labor,
L

The
The real
real wage
wage adjusts
adjusts to
to
equate
equate
demand
with
CHAPTER labor
3labor
National
Income
demand
with supply.
supply.

slide 22

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 firms demand curve

for renting capital.

Firms maximize profits by choosing K

such that MPK = R/P .

CHAPTER 3

National Income

slide 23

The equilibrium real rental rate

Units of
output

Supply of
capital

equilibriu
m R/P
K

CHAPTER 3

National Income

The
The real
real rental
rental
rate
rate adjusts
adjusts to
to
equate
equate
demand
demand for
for
capital
capital with
with
supply.
supply.
MPK,
demand for
capital
Units of capital,
K

slide 24

The
The Neoclassical
Neoclassical Theory
Theory
of
of Distribution
Distribution
states
states that
that each
each factor
factor input
input isis
paid
paid its
its marginal
marginal product
product

accepted
accepted by
by most
most economists
economists

CHAPTER 3

National Income

slide 25

How income is distributed:

P
L
W

MPLL

P
K
R

MPKK

total labor income =

total capital income

=
If production function has constant
returnsYMPLLMPKK
to
scale,
then

national
income
CHAPTER 3

labor
income
National Income

capital
income
slide 26

Outline of model
A closed economy, market-clearing model
Supply side
DONE
factor markets (supply, demand,
DONE price)
determination of output/income
Demand side
Next
determinants of C, I, and G
Equilibrium
goods market
loanable funds market
CHAPTER 3

National Income

slide 27

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 28

Consumption, C
def: disposable income is total
income minus total taxes:

YT

Consumption function: C = C (Y T )
Shows that (Y T ) C

def: The marginal propensity to

consume is the increase in C caused
by a one-unit increase in disposable
income.

CHAPTER 3

National Income

slide 29

The consumption function

C

C (Y
T)

MPC
1

The slope of the

consumption
function is the
MPC.
YT

CHAPTER 3

National Income

slide 30

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
ones
own funds
to finance investment spending.
So, r I
CHAPTER 3

National Income

slide 31

The investment function

r

Spending on
investment goods
is a downwardsloping function of
the real interest
rate
I
(r )
I

CHAPTER 3

National Income

slide 32

Government spending, G
G includes government spending on
goods and services.

G excludes transfer payments

Assume government spending and
total taxes are exogenous:

and
GGTT

CHAPTER 3

National Income

slide 33

The market for goods & services

CYTI

Agg. rG
demand:

YFKL
Agg. supply:
YCYTI

Equilibrium:
rG

()()
(,)
= ()()

The
The real
real interest
interest rate
rate adjusts
adjusts
to
to equate
equate demand
demand with
with supply.
supply.

CHAPTER 3

National Income

slide 34

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 35

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 (the cost of

borrowing).
CHAPTER 3

National Income

slide 36

Loanable funds demand curve

r

The investment
curve is also the
demand curve
for loanable
funds.
I
(r )
I
CHAPTER 3

National Income

slide 37

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 of the tax

revenue it receives.
CHAPTER 3

National Income

slide 38

Types of saving
private saving = (Y T ) C
public saving

T G

national saving, S
= private saving + public saving
= (Y T ) C +
=

CHAPTER 3

TG

C G

National Income

slide 39

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.
L PL
M
.Y

More generally, if K = 0, then

(YT ) = Y T , so
C

MPC (Y T )

= MPC Y MPC T
CHAPTER 3

National Income

slide 40

EXERCISE:

Calculate the change in saving

Suppose MPC = 0.8 and MPL = 20.
For each of the following, compute
S :
a. G = 100
b. T = 100
c. Y = 100
d. L =

CHAPTER 3

10

National Income

slide 41

Answers

YYTG
0.8()

YCG

YTG
0.20.8

.
1

S
0
a
0

S
108
b.
0.800

S
102
c.
0.200

YMPL201020,
0
d.

SY
0.20.220040.

CHAPTER 3

National Income

slide 42

digression:

Budget surpluses and deficits

When T > G ,
budget surplus = (T G ) = public
saving

When T < G ,
budget deficit = (G T )
and public saving is negative.

When T = G ,
budget is balanced and public saving = 0.

CHAPTER 3

National Income

slide 43

The U.S. Federal Government Budget

5%

0%

-5%

percent of GDP
-10%

(T-G)
(T-G)as
asaapercent
percentof
ofGDP
GDP

-15%
1940

CHAPTER 3

1950

1960

1970

National Income

1980

1990

2000

slide 44

The U.S. Federal Government Debt

Fact:
Fact: In
Inthe
theearly
early1990s,
1990s,
about
about18
18cents
centsof
ofevery
everytax
tax
dollar
dollarwent
wentto
topay
payinterest
intereston
on
the
thedebt.
debt.
(Today
(Todayits
itsabout
about99cents.)
cents.)

120%
100%
80%
60%
percent of GDP
40%
20%
1940

1950

CHAPTER 3

1960

1970

National Income

1980

1990

2000

slide 45

Loanable funds supply curve

r

SYCYTG
()

National
saving does
not depend
on r,
so the supply
curve is
vertical.
S, I

CHAPTER 3

National Income

slide 46

Loanable funds market equilibrium

r

SYCYTG
()

Equilibrium real
interest rate

I (r )
Equilibrium level
of investment
CHAPTER 3

National Income

S, I

slide 47

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
Y
Y C
C G
G =
= II
Add
Add (C
(C +G
+G )) to
to both
both sides
sides to
to get
get
Y
Y=
=C
C+
+ II +
+G
G (goods
(goods market
market eqm)
eqm)
Eqm in
Eqm in
Thus,
Thus, L.F.
goods
market
market

CHAPTER 3

National Income

slide 48

Digression: mastering models

To learn a model well, 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 49

Mastering the loanable funds model

1. 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

CHAPTER 3

National Income

slide 50

CASE STUDY

The Reagan Deficits

Reagan policies during early 1980s:
increases in defense

spending: G > 0
big tax cuts: T < 0

According to our model, both policies

reduce national saving:

SYCYTG
()

GS

CHAPTER 3

TCS

National Income

slide 51

1. The Reagan deficits, cont.

1. The increase in
the deficit
reduces saving
2. which causes
the real interest
rate to rise

S
1

r2
r1

3. which reduces
the level of
investment.
CHAPTER 3

S
2

National Income

I (r )
I2

I1

S, I
slide 52

Are the data consistent with these results?

variable
variable
TT G
G

1970s
1970s
2.2
2.2

1980s
1980s
3.9
3.9

SS
rr

19.6
19.6
1.1
1.1

17.4
17.4
6.3
6.3

II

19.9
19.9

19.4
19.4

TG, S, and I are expressed as a percent of GDP

All figures are averages over the decade shown.
CHAPTER 3

National Income

slide 53

Now you try

Draw the diagram for the loanable
funds model.

Suppose the tax laws are altered to

provide more incentives for private
saving.

What happens to the interest rate and

investment?

(Assume that T doesnt change)

CHAPTER 3

National Income

slide 54

Mastering the loanable funds model

2. Things that shift the investment curve
certain technological innovations
to take advantage of the innovation,

firms must buy new investment

goods
tax laws that affect investment
investment tax credit

CHAPTER 3

National Income

slide 55

An increase in investment demand

r
raises the
interest rate.

r2

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 56

Chapter summary
1. Total output is determined by
how much capital and labor the economy

has
the level of technology

2. Competitive firms hire each factor until its

marginal product equals its price.

3. If the production function has constant

returns to scale, then labor income plus
capital income equals total income (output).

CHAPTER 3

National Income

slide 59

Chapter summary
4. The economys output is used for
consumption

(which depends on disposable income)

investment
(depends on the real interest rate)
government spending
(exogenous)

5. The real interest rate adjusts to equate

the demand for and supply of
goods and services
loanable funds
CHAPTER 3

National Income

slide 60

Chapter summary
6. A decrease in national saving causes the
interest rate to rise and investment to fall.

7. 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.

CHAPTER 3

National Income

slide 61

CHAPTER 3

National Income

slide 62