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Macroeconomics Sixth Edition

N. Gregory Mankiw. Macroeconomics Sixth Edition. Chapter 3: National Income: Where it Comes From and Where it Goes. Econ 4020/Chatterjee. In this chapter, you will learn…. How an economy’s total output/income is produced How the prices of the factors of production are determined

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Macroeconomics Sixth Edition

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  1. N. Gregory Mankiw Macroeconomics Sixth Edition Chapter 3: National Income:Where it Comes From and Where it Goes Econ 4020/Chatterjee CHAPTER 3 National Income

  2. In this chapter, you will learn… • 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 CHAPTER 3 National Income

  3. 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 CHAPTER 3 National Income

  4. CHAPTER 3 National Income

  5. 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 CHAPTER 3 National Income

  6. The production function • denoted Y = F(K,L) • shows how much output (Y) the economy can produce fromKunits of capital and Lunits of labor • reflects the economy’s level of technology • exhibits “constant returns to scale” CHAPTER 3 National Income

  7. 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 CHAPTER 3 National Income

  8. Assumptions of the model • Technology is fixed. • The economy’s supplies of capital and labor are fixed at Why? Because we are looking at the “long run” where all resources are fully utilized or employed CHAPTER 3 National Income

  9. Determining GDP Output is determined by the fixed factor supplies and the fixed state of technology: CHAPTER 3 National Income

  10. 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

  11. 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

  12. 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

  13. 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 CHAPTER 3 National Income

  14. 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) CHAPTER 3 National Income

  15. MPL 1 As more labor is added, MPL  MPL 1 Slope of the production function equals MPL 1 MPL and the production function Y output MPL L labor CHAPTER 3 National Income

  16. 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 CHAPTER 3 National Income

  17. 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 MPL = W/P. CHAPTER 3 National Income

  18. 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. CHAPTER 3 National Income

  19. 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. CHAPTER 3 National Income

  20. 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. CHAPTER 3 National Income

  21. The ratio of labor income to total income in the U.S. Labor’s share of total income Labor’s share of income is approximately constant over time.(Hence, capital’s share is, too.) CHAPTER 3 National Income

  22. The Cobb-Douglas Production Function • The Cobb-Douglas production function is: 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 • . CHAPTER 3 National Income

  23. The Cobb-Douglas Production Function • Each factor’s marginal product is proportional to its average product: CHAPTER 3 National Income

  24. nationalincome capitalincome laborincome How income is distributed: total labor income = total capital income = If production function has constant returns to scale, then CHAPTER 3 National Income

  25. Empirical estimates of the Cobb-Douglas 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. CHAPTER 3 National Income

  26. The ratio of labor income to total income in the U.S. Labor’s share of total income Labor’s share of income is approximately constant over time.(Hence, capital’s share is, too.) CHAPTER 3 National Income

  27. 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. CHAPTER 3 National Income

  28. 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 CHAPTER 3 National Income

  29. 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? CHAPTER 3 National Income

  30. CHAPTER 3 National Income

  31. 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 DONE DONE  Next CHAPTER 3 National Income

  32. 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 ) CHAPTER 3 National Income

  33. Gross Domestic Product, USA [Billions of dollars]   Seasonally adjusted at annual rates Source: Bureau of Economic Analysis CHAPTER 3 National Income

  34. 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: Marginal propensity to consume (MPC)is the increase in C caused by a one-unit increase in disposable income. CHAPTER 3 National Income

  35. C C(Y –T) The slope of the consumption function is the MPC. MPC 1 Y – T The consumption function CHAPTER 3 National Income

  36. 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 CHAPTER 3 National Income

  37. r Spending on investment goods depends negatively on the real interest rate. I(r) I The investment function CHAPTER 3 National Income

  38. Government spending, G • G = govt spending on goods and services. • Assume government spending and total taxes are exogenous: CHAPTER 3 National Income

  39. The market for goods & services • Aggregate demand: • Aggregate supply: • Equilibrium: • The real interest rate adjusts to equate demand with supply. CHAPTER 3 National Income

  40. 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

  41. 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

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

  43. 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

  44. 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 CHAPTER 3 National Income

  45. r S, I Loanable funds supply curve National saving does not depend on r, so the supply curve is vertical. CHAPTER 3 National Income

  46. r Equilibrium real interest rate I(r) Equilibrium level of investment S, I Loanable funds market equilibrium CHAPTER 3 National Income

  47. 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

  48. U.S. Federal Government Surplus/Deficit, 1940-2004 CHAPTER 3 National Income

  49. 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.) CHAPTER 3 National Income

  50. The U.S. Budget Deficit: Where is it Headed? CHAPTER 3 National Income

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