Instructor Sandeep Basnyat Sandeep_basnyat@yahoo 9841 892281

1. Macroeconomics & The Global EconomyTerm IIIAce Institute of ManagementChapter 3: National income-where it comes and where it goes? Instructor Sandeep Basnyat Sandeep_basnyat@yahoo.com 9841 892281

2. What Macroeconomics study? • Some of the foremost important questions that macroeconomics tries to investigate are: • What determines the total income in an economy? • What determines the level of production in an economy? • Who gets the income from production? • How the income is distributed among the factors of production? In general, How the economy works? Simple demonstration: Circular Flow of Income Model

3. Equilibrium Level of National Income Foreign Sector International Capital Flows Exports (X) Imports (M) Consumption Expenditure (C) Market for goods and Services National Products Government Purchase (G) Transfer Payments Government Investment (I) Taxes (T) Firms Households Loans Repay Loans or Investment Funds Savings (S) Financial Services National Income (Y) Market for Factors of Production Wages, Interest, Rent and Profit S + T + M = I + G + X Total Leakages = Total Injections Aggregate Demand (AD) = Aggregate Supply (AS)

4. How do the interactions occur in an economy?Our first theory:the Neo classical theory (based on classical theory)

5. P S P* D Q* Q Welcome to... The Classical Factory The place where Classical-model mechanics are made easy!

6. What is the Classical Model? • Its roots go back to 1776—to Adam Smith’s Wealth of Nations. • Economy was controlled by the “invisible hand” • Market system, instead of government mechanism • Buyers and sellers pursuing their own self-interest • Emphasis on competition and flexible wages/prices • Prices adjust to balance supply and demand in an economy • Economy usually maintains Full employment of resources and general equilibrium in economy

7. How will we proceed? • Sequence of Questions and Answers: • What determines the level of output (or National Income) in an economy? • What determines the distribution of national income among factors of production? • What determines the factor prices? • What determines the demand for factor of production?

8. An economy’s output of goods and services (GDP) depends on: • Quantity of inputs : Factors of Production (Capital and Labour) • Ability to turn inputs into output : Production Function What determines the Total Production of Goods and Services?

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

10. The production function • Usually denoted Y = F (K,L) • Shows how much output (Y ) the economy can produce from Kunits of capital and Lunits of labor. • Reflects the economy’s level of technology. • Assumption: exhibits constant returns to scale (Meaning: If we increase inputs by z, output will also increase by z.)

11. 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

12. Other assumptions of the model • Technology is fixed. • The economy’s supplies of capital and labor are fixed at

13. Determining Output: GDP • Factors of Production and Production Function together determine the Total Output in the Economy. • Since Technology (production function) and K and L are assumed to be fixed, the output (Y) is also assumed to be fixed in an economy. Y = Y

14. How will we proceed? • Sequence of Questions and Answers: • What determines the level of output (or National Income) in an economy? • Factors of Production and the Production function • What determines the distribution of national income among factors of production? • What determines the demand for factors of production?

15. 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.

16. Notation W = nominal wage R = nominal rental rate P = price of output W/P = real wage (measured in units of output) [Note: P = i (inflation) reflects price level and Real Wage rate in %] R/P = real rental rate

17. 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?

18. Factor price (Wage or rental rate) Factor supply This vertical supply curve is a result of the supply being fixed. Equilibrium factor price Factor demand Quantity of factor Determination of Factor Prices Factor prices are determined by supply and demand in factor markets. What about demand?

19. Factor Prices • Because the factor supply curve is vertical and fixed, it is the demand curve for the factors of productions which determines the distribution of income among them. • Big Question: What determines the demand for factors of production?

20. The Firm's Demand for Factors We know that the firm will hire labor and rent capital in the quantities that maximize profit. But what are those maximizing quantities? Answer: Depends upon Marginal Revenue earned from Marginal Product of Labour and Marginal Product of Capital.

21. 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)

22. MPL 1 As more labor is added, MPL  MPL 1 Slope of the production function equals MPL 1 The MPL and the production function Y output MPL L labor

23. 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

24. Units of output Real wage MPL, Labor demand Units of labor, L Quantity of labor demanded MPL and the demand for labor Each firm hires labor up to the point where P × MPL (VMPL) = W MPL= W/P

25. Labor supply Units of output equilibrium real wage MPL, Labor demand Units of labor, L The equilibrium real wage The real wage adjusts to equate labor demand with supply.

26. 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 MPKcurve is the firm’s demand curve for renting capital. • Firms maximize profits by choosing Ksuch that MPK = R/P.

27. Units of output Supply of capital equilibrium R/P MPK, demand for capital Units of capital, K The equilibrium real rental rate The real rental rate adjusts to equate demand for capital with supply.

28. nationalincome capitalincome laborincome How income is distributed: total labor income = total capital income = If production function has constant returns to scale, then

29. The Division of National Income The income that remains after firms have paid the factors of production is the economic profit of the firms’ owners. Real economic profit is: Economic Profit = Y - (MPL × L) - (MPK × K) or to rearrange: Y = (MPL × L) + (MPK × K) + Economic Profit. Usually we find (Lumping Y and MPL into Eco. Profit): Accounting Profit = Economic Profit + (MPK x K)

30. The Cobb-Douglas Production Function Paul Douglas observed that the division of national income between capital and labor has been roughly constant over time. In other words, the total income of workers and the total income of capital owners grew at almost exactly the same rate. He then wondered what conditions might lead to constant factor shares. Cobb, a mathematician, said that the production function would need to have the property that: Paul Douglas Capital Income = MPK × K = αY Labor Income = MPL × L = (1- α) Y

31. Cobb–Douglas Production Function Capital Income = MPK × K = α Y Labor Income = MPL × L = (1- α) Y αis a constant and measures capital and labors’ share of income. Cobb-Douglas Production Function Cobb showed that the function with this property is: F (K, L) = A Kα L1- α A is a parameter that measures the productivity of the available technology. (Total Factor Productivity)

32. Cobb–Douglas Production Function Cobb–Douglas Production Function: Y = F (K, L) = A Kα L1- α Differentiating, we get the Marginal product of labor: MPL = (1- α) A Kα L–α Multiply and Divide right hand side by L. Then, MPL = (1- α) [A Kα L–α] L / L = (1- α) [A Kα L1-α] / L MPL = (1- α) Y / L Similarly, The Marginal product of capital is: MPK = α A Kα-1L1–αor, MPK = αY/K Average Labour Productivity Average Capital Productivity

33. Properties of the Cobb–Douglas Production Function (1) Consider the Cobb–Douglas production function: MPL = (1- α)Y/L ………….(i) MPK= αY/ K ………………(ii) Equation (i) tells us that marginal product of the labour is proportional to output per worker (average productivity of worker). Similarly, equation (ii) states that marginal product of the capital is proportional to the output per unit of capital (average productivity of capital). In conclusion, Marginal productivity of a factor is proportional to its average productivity.

34. Properties of the Cobb–Douglas Production Function 2) The Cobb–Douglas production function has constant returns to scale. That is, if capital and labor are increased by the same proportion, then output increases by the same proportion as well. Proof: Consider the Cobb-Douglas Production function: F (K, L) = A Kα L1- α F(zK,zL) = A(zK)α (zL)1- α F(zK,zL) = Az α Kαz1- αL1- α F(zK,zL) = Az α z1- α KαL1- α F(zK,zL) = Az α+1- α KαL1- α F(zK,zL) = AzKαL1- α= zAKαL1- α= zF(K,L) = zY Therefore, Cobb-Douglas production function has constant returns to scale.

35. Empirical Evidence of the Cobb–Douglas Production Function • According to C.D. Prod. Func. : MPL α Y/L • According to Neo Classical Theory, MPL = W /P • So, MPL α W/P Growth in Labour productivity and Real Wages in US Period Labour Productivity Real Wages Growth rate Growth rate 1959-1973 2.9% 2.8% 1973-1995 1.4% 1.2% 1995-2003 3.0% 3.0% 1995-2003 2.1% 2.0% Source: US Economic Report of the President, 2005. FYI: Prepare list of some of countries that support Cobb-Douglas production function with their growth rates.

36. How will we proceed? • Sequence of Questions and Answers: • What determines the level of output (or National Income) in an economy? • Factors of Production and the Production function • What determines the distribution of national income among factors of production? • Factor Prices • What determines the demand for factors of production?

37. 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 )

38. Consumption, C • def: disposable income is total income minus total taxes: Y – T • Consumption function: C = C (Y – T ) Shows that (Y – T )  C • def: The marginal propensity to consumeis the increase in C caused by a one-unit increase in disposable income. • MPC = (YT ) / C = (Y  T ) / C • Or, C = MPC  (Y  T )

39. C C(Y –T ) The slope of the consumption function is the MPC. MPC 1 Y – T The consumption function

40. Investment, I • The investment function is I = I (r ), where rdenotes 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

41. r Spending on investment goods is a downward-sloping function of the real interest rate I(r) I The investment function

42. Government spending, G • G includes government spending on goods and services. • G excludes transfer payments • Assume government spending and total taxes are exogenous:

43. 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.

44. Equilibrium in The market for goods & services The real interest rate adjusts to equate demand with supply.

45. Equilibrium in the Financial Market: 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

46. 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).

47. r I(r) I Loanable funds demand curve The investment curve is also the demand curve for loanable funds.

48. 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.

49. Types of saving • private saving= (Y –T ) – C • public saving = T – G • national saving, S = private saving + public saving = (Y –T ) – C + T – G = Y – C – G

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