MACROECONOMICS

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Oct 28, 2013 (3 years and 11 months ago)

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MACROECONOMICS
© 2013 Worth Publishers, all rights reserved
PowerPoint

®
Slides by Ron Cronovich
N. Gregory Mankiw
National Income: Where It Comes
From and Where It Goes
3
Modified for EC 204
by Bob Murphy
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
2
CHAPTER 3

National Income
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
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
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
§
reflects the economy’s level of technology
§
exhibits constant returns to scale
CHAPTER 3

National Income
Returns to scale: a review
Initially
Y
1


=
F

(
K
1

,

L
1
)
Scale all inputs by the same factor
z
:

K
2
=
zK
1
and
L
2
=
zL
1

(
e.g.
, if
z
= 1.2, then all inputs are increased by 20%)
What happens to output,
Y
2
=
F
(
K
2
,

L
2

)?
§
If
constant returns to scale
,
Y
2
=
zY
1

§
If
increasing returns to scale
,
Y
2
>
zY
1

§
If
decreasing returns to scale
,
Y
2
<
zY
1

NOW YOU TRY
Returns to scale
§
Determine whether each of these production
functions has constant, decreasing, or increasing
returns to scale:
(a)
(b)
7
ANSWERS
Returns to scale, part (a)
8
constant returns to
scale for any
z
> 0
ANSWERS
Returns to scale, part (b)
9
constant returns to
scale for any
z
> 0
CHAPTER 3

National Income
Assumptions
1.
Technology is fixed.
2.
The economy’s supplies of capital and labor
are fixed at
CHAPTER 3

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

National Income
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
CHAPTER 3

National Income
Notation
CHAPTER 3

National Income
How factor prices are determined
§
Factor prices determined by supply and demand
in factor markets.
§
Recall: Supply of each factor is fixed.
§
What about demand?
CHAPTER 3

National Income
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
Marginal product of labor (MPL

)
§
definition:
The extra output the firm can produce
using an additional unit of labor
(holding other inputs fixed):

M P L
=
F

(
K
,

L

+ 1 ) –

F

(
K
,

L
)
CHAPTER 3

National Income
Y
output
MPL and the production function
L
labor
1
MPL
1
MPL
1
MPL
Slope of the production
function equals
MPL
CHAPTER 3

National Income
Diminishing marginal returns
§
As an 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
MPL and the demand for labor
Units of
output
Units of labor,
L
MPL
, Labor
demand
Real
wage
Quantity of labor
demanded
CHAPTER 3

National Income
The equilibrium real wage
Units of
output
Units of labor,
L
MPL
, Labor
demand
equilibrium
real wage
Labor
supply
CHAPTER 3

National Income
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
.
CHAPTER 3

National Income
The equilibrium real rental rate
Units of
output
Units of capital,
K
MPK, demand
for capital
equilibrium
R/P
Supply of
capital
CHAPTER 3

National Income
The Neoclassical Theory of Distribution
§
states that each factor input is paid its marginal
product
§
a good starting point for thinking about income
distribution
CHAPTER 3

National Income
How income is distributed to L and K
total labor income =
If production function has constant returns to
scale, then
total capital income =
labor
income
capital
income
national
income
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
The ratio of labor income to total income
in the U.S.,
1960-2010
Labor’s
share of
total
income
Labor’s share of income
is approximately constant over time.
(Thus, capital’s share is, too.)
CHAPTER 3

National Income
The Cobb-Douglas Production Function
§
The Cobb-Douglas production function has
constant factor shares:

α
= capital’s share of total income:
capital income =
MPK
×
K
=
α

Y
labor income =
MPL
×
L
= (1 –
α
)
Y
§
The Cobb-Douglas production function is:

where
A
represents the level of technology.
CHAPTER 3

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

National Income
Labor productivity and wages
§
Theory: wages depend on labor productivity
§
U.S. data:
period
productivity
growth
real wage
growth
1960–2010
2.2%
1.9%
1960–1973
2.9%
2.8%
1973–1995
1.4%
1.2%
1995–2010
2.7%
2.2%
CHAPTER 3

National Income
Outline of model
A closed economy, market-clearing model
Supply side
q
factor markets (supply, demand, price)
q
determination of output/income
Demand side
q
determinants of
C
,
I
, and
G
Equilibrium
q
goods market
q
loanable funds market
DONE
ü
DONE

ü
Next
è
CHAPTER 3

National Income
Demand for goods and 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
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 change in
C
when disposable income
increases by one dollar.
CHAPTER 3

National Income
The consumption function
C
Y – T
C

(
Y

T
)
1
MPC
The slope of the
consumption function
is the
MPC
.
CHAPTER 3

National Income
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
The investment function
r
I
I

(
r

)
Spending on
investment goods
depends negatively on
the real interest rate.
CHAPTER 3

National Income
Government spending, G
§
G
= government spending on goods and services
§
G
excludes transfer payments

(
e.g
., Social Security benefits,
unemployment insurance benefits)
§
Assume government spending and total taxes are
exogenous:
CHAPTER 3

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

National Income
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
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
Loanable funds demand curve
r
I
I

(
r

)
CHAPTER 3

National Income
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
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
Notation:
Δ
= change in a variable
§
For any variable
X
,
Δ
X
= “change in
X


Δ
is the Greek (uppercase) letter
Delta
Examples:
§
If
Δ
L
= 1 and
Δ
K
= 0, then
Δ
Y
=
MPL
.
More generally, if
Δ
K
= 0, then
§
Δ
(
Y

T
)

=
Δ
Y
−Δ
T
, so


Δ
C
=
M P C
×
(
Δ
Y
−Δ
T
)
=
MPC

Δ
Y
−
MPC

Δ
T
CHAPTER 3

National Income
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.
U.S. Federal Government Surplus/Deficit,
1940–2016
percent of GDP
-35
-30
-25
-20
-15
-10
-5
0
5
10
1940
1950
1960
1970
1980
1990
2000
2010
U.S. Federal Government Debt,
1940–2016
percent of GDP
0
20
40
60
80
100
120
140
1940
1950
1960
1970
1980
1990
2000
2010
CHAPTER 3

National Income
Loanable funds supply curve
r
S, I
CHAPTER 3

National Income
Loanable funds market equilibrium
r
S, I
I

(
r

)
Equilibrium real
interest rate
Equilibrium level
of investment
CHAPTER 3

National Income
The special role of
r
Eq’m in L.F.
market
Eq’m in goods
market
CHAPTER 3

National Income
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.
CHAPTER 3

National Income
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

401(k)

IRA

replace income tax with consumption tax
CHAPTER 3

National Income
CASE STUDY:
The Reagan deficits
§
Reagan policies during early 1980s:
§
increases in defense spending:
Δ
G
> 0
§
big tax cuts:
Δ
T
< 0
§
Both policies reduce national saving:
CHAPTER 3

National Income
CASE STUDY:
The Reagan deficits
r
S, I
I

(
r

)
r
1
I
1
r
2
I
2
CHAPTER 3

National Income
Are the data consistent with these results?

1970s 1980s
T

G
–2.2 –3.9
S
19.6 17.4
r
1.1 6.3

I
19.9 19.4
T

G
,
S
, a n d
I
a r e e x p r e s s e d a s a p e r c e n t o f G D P
A l l f i g u r e s a r e a v e r a g e s o v e r t h e d e c a d e s h o w n.
NOW YOU TRY
The effects of saving incentives
§
Draw the diagram for the loanable funds model.
§
Suppose the tax laws are altered to provide more
incentives for private saving.
(Assume that total tax revenue
T
does not
change)
§
What happens to the interest rate and
investment?
54
CHAPTER 3

National Income
Mastering the loanable funds model
,
continued
Things that shift the investment curve:
§
some technological innovations
§
to take advantage some innovations,
firms must buy new investment goods
§
tax laws that affect investment
§
e.g.,
investment tax credit
CHAPTER 3

National Income
An increase in investment demand
An increase
in desired
investment

r
S, I
I
1
I
2
r
1
r
2

raises the
interest rate.
But the equilibrium
level of investment
cannot increase
because the
supply of loanable
funds is fixed.
CHAPTER 3

National Income
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?
CHAPTER 3

National Income
An increase in investment demand when
saving depends on r
r
S, I
I
(
r
)
I
(
r
)
2
r
1
r
2
I
1
I
2
C H A P T E R S U M M A R Y
§
To t a l o u t p u t i s d e t e r mi n e d b y:
§
t h e e c o n o my ’ s q u a n t i t i e s o f c a p i t a l a n d l a b o r
§
t h e l e v e l o f t e c h n o l o g y
§
C o mp e t i t i v e f i r ms h i r e e a c h f a c t o r u n t i l i t s ma r g i n a l
p r o d u c t e q u a l s i t s p r i c e.
§
I f t h e p r o d u c t i o n f u n c t i o n h a s c o n s t a n t r e t u r n s t o
s c a l e, t h e n l a b o r i n c o me p l u s c a p i t a l i n c o me
e q u a l s t o t a l i n c o me ( o u t p u t ).
59
C H A P T E R S U M M A R Y
§
A c l o s e d e c o n o my ’ s o u t p u t i s u s e d f o r
c o n s u mp t i o n, i n v e s t me n t, a n d g o v e r n me n t
s p e n d i n g.
§
T h e r e a l i n t e r e s t r a t e a d j u s t s t o e q u a t e
t h e d e ma n d f o r a n d s u p p l y o f:
§
g o o d s a n d s e r v i c e s.
§
l o a n a b l e f u n d s.
60
C H A P T E R S U M M A R Y
§
A d e c r e a s e i n n a t i o n a l s a v i n g c a u s e s t h e i n t e r e s t
r a t e t o r i s e a n d i n v e s t me n t t o f a l l.
§
A n i n c r e a s e i n i n v e s t me n t d e ma n d c a u s e s t h e
i n t e r e s t r a t e t o r i s e b u t d o e s n o t a f f e c t t h e
e q u i l i b r i u m l e v e l o f i n v e s t me n t i f t h e s u p p l y o f
l o a n a b l e f u n d s i s f i x e d.
61