INTERMEDIATE MACROECONOMICS

LECTURE NOTES
(ECN 2215)

BANDA, CM
It is a simple but powerful analytical model built around buyers and
sellers pursuing their own self-interest (within rules set by
government). It’s emphasis is on the consequences of competition
and flexible wages/prices for total employment and real output. Its
roots go back to 1776—to Adam Smith’s Wealth of Nations. The
Wealth of Nations suggested that the economy was controlled by
the “invisible hand” whereby the market system, instead of
government would be the best mechanism for a healthy economy.
The heart of the market system lies in the “market clearing” process
and the consequences of individuals pursuing self-interest.

Copyright 1997 Dead Economists Society

 Neoclassical theory of distribution

We are going to examine carefully the modern theory of how

national income is distributed among the factors of production.
The theory is based on :
The classical (eighteenth-century) idea that prices adjust to balance
supply and demand.
The more recent (nineteenth-century) idea that the demand for each
factor of production depends on the marginal productivity of that
factor.
The Neoclassical model
Is a general equilibrium model:
• Involves multiple markets
• each with own supply and demand
• Prices in each market adjusts to make
quantity demanded equal quantity supplied.
Three Markets – Three agents
Labor Market hiring
work

Financial Market
saving borrowing borrowing

Households Government Firms

production
government
consumption spending investment

Goods Market
Neoclassical model
Agents interact in markets, where they
may be demander in one market and
supplier in another .
1) Goods market:
Supply: Firms supply goods and services
Demand: by households for consumption,
government spending, and other firms
demand them for investment
Neoclassical model
2) Labor market (factors of production)
Supply: Households
Demand: Firms hire labor to produce

3) Capital market
Supply: Households through savings
Demand: firms borrow funds for investment;
government borrows funds to finance
expenditures.
Neoclassical model continued..
• We will develop a set of equations to
characterize supply and demand in these
markets

• Then use algebra to solve these equations

together, and see how they interact to
establish a general equilibrium.

• Start with production…

Part 1: Supply in goods market: Production
Supply in the goods market depends on a production function: denoted
Y = F (K,L)
• It 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.
• Generally, we will assume it exhibits constant returns to scale.
 Returns to scale
Initially Y1 = F (K1 ,L1 )
Scale all inputs by the same factor z:
K2 = zK1 and L2 = zL1 for z>1
(If z = 1.25, then all inputs increase 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
Exercise: determine returns to scale
Determine whether the production function
below has constant, increasing, or decreasing
returns to scale:

F (K , L )  2K  15L
Additional assumptions of the model
1. Technology is fixed.
2. The economy’s supplies of capital and labor
are fixed at

K K and L L
Recall that the total output of an economy equals total income.
Because the factors of production and the production function
together determine the total output of goods and services, they also
determine national income.

The distribution of national income is determined by factor prices.

Factor prices are the amounts paid to the factors of production—the
wages workers earn and the rent the owners of capital collect.
Because we have assumed a fixed amount of
capital and labor, the factor supply curve is a vertical line.
Part 2: Equilibrium in the factors market

• Equilibrium is where factor supply equals factor

demand.
• Recall: Supply of factors is fixed.
• Demand for factors comes from firms.
The price paid to any factor of production depends on the supply and
demand for that factor’s services. Because we have assumed that
the supply is fixed, the supply curve is vertical. The demand curve
is downward sloping. The intersection of supply and demand
determines the equilibrium factor price.

Factor Factor supply

price
(Wage or This vertical supply curve
rental is a result of the
rate) supply being fixed.

Equilibrium
Factor demand
factor price
Quantity of factor
Demand in factors market
Analyze the decision of a typical firm
• It buys labor in the labor market, where w is the
price of labor or the wage.
• It rents capital in the factors market, at the price
denoted as r, the interest rate.
• It uses labor and capital to produce the good,
which it sells in the goods market, at price P.
Demand in factors market
Assume the market is competitive:
Each firm is small relative to the market, so its actions do not affect the
market prices.
It takes the price as given.
It then chooses the optimal quantity of Labor and capital to maximize
its profit.
Profit equation:
Profit = revenue -labor costs -capital costs
Profit is revenue minus cost. Revenue equals P × Y. Costs include
both labor and capital costs.
Labor costs equal W × L, the wage multiplied by the amount
of labor L. Capital costs equal R × K, the rental price of capital R times
the amount of capital K.

Profit = Revenue - Labor Costs - Capital Costs

= PY - WL - RK

Then, to see how profit depends on the factors of production, we use

production function Y = F (K, L) to substitute for Y to obtain:

Profit = P × F (K, L) - WL - RK

This equation shows that profit depends on P, W, R, L, and K. The

competitive firm takes the product price and factor prices as given
and chooses the amounts of labor and capital that maximize profit.
The marginal product of labor (MPL) is the extra amount of output the
firm gets from one extra unit of labor, holding the amount of
capital fixed and is expressed using the production function:
MPL = F(K, L + 1) - F(K, L).
Most production functions have the property of
diminishing marginal product: holding the amount of capital
fixed, the marginal product of labor decreases as the amount of labor
increases.
The MPL is the change in output Y
when the labor input is increased
F (K, L)
by 1 unit. As the amount of labor MPL
increases, the production function 1
becomes flatter, indicating MPL
diminishing marginal product.
1
L
Diminishing marginal returns

• Intuition:
L while holding K fixed
fewer machines per worker
Over crowding
 lower productivity
MPL with calculus
MPL as a derivative
As we take the limit for small change in L:
F (K , L  L )  F (K , L )
MPL  lim
L 0 L
 f L (K , L )
Which is the definition of the (partial) derivative of the production
function with respect to L, treating K as a constant.
This shows the slope of the production function at any particular
point, which is what we want.
The MPL and the production function
Y
output
MPL is slope of the F (K , L )
production function
(rise over run)

F (K, L +L) – F (K, L))

L

L
labor
Derivative as marginal product
1
Y
2)Y  F (L )  3L  3 L
2

1 4 9 L

L: 1 4 9
F(L): 3 6 9
fL: 1.5 0.75 0.5
When the competitive, profit-maximizing firm is
deciding whether to hire an additional unit of labor, it
considers how that decision would affect profits. It
therefore compares the extra revenue from the increased
production that results from the added labor to the extra
cost of higher spending on wages. The increase in revenue
from an additional unit of labor depends on two variables:
the marginal product of labor, and the price of the output.
Because an extra unit of labor produces MPL units of output
and each unit of output sells for P dollars, the extra revenue
is P × MPL. The extra cost of hiring one more unit of labor
is the wage W. Thus, the change in profit from hiring
an additional unit of labor is ∆ Profit = ∆ Revenue - ∆ Cost
= (P × MPL) - W
 Thus, the firm’s demand for labor is determined by P × MPL = W,
or in another way MPL = W/P, where W/P is the real wage– the
payment to labor measured in units of output rather than in
monetary units. To maximize profit, the firm hires up to the point
where the extra revenue equals the real wage.
Units of The MPL depends on the amount of labor.
output
The MPL curve slopes downward because
the MPL declines as L increases. This
Real schedule is also the firm’s labor demand
wage curve.

Quantity of labor demanded

MPL, labor demand

Units of labor, L
Firm problem continued: hiring L
Firm chooses L to maximize its profit.
How will increasing L change profit?
 profit =  revenue -  cost
= (P  MPL) – W
If this is: > 0 firm should hire more labor
< 0 should layoff labor
= 0 maintain current labor
Firm problem continued
So the firm’s demand for labor is determined by the condition:
(P  MPL) = W.
Hires more and more L, until MPL falls enough to satisfy the condition.

Also may be written as:

MPL = W/P , where W/P is the ‘real wage’
Firm problem continued
So the firm’s demand for labor is determined by the condition:
(P  MPL) = W.
Hires more and more L, until MPL falls enough to satisfy the condition.

Also may be written as:

MPL = W/P , where W/P is the ‘real wage’
Real wage
Think about units:
• W = Wage
• P = price of the good produced
• W/P = ($/hour) / ($/good) = Real wage
The amount of purchasing power, measured in units
of goods, that firms pay per unit of work.
Example: deriving labor demand
• Suppose a production function for all firms in the economy:
Y K L 0.5 0.5

Find the labour demand function:

Recall we discussed already that the firm
will demand until the marginal
productivity of labour equal the real wage.
Labor demand continued
or rewrite with L as a function of real wage
W
0.5K L
0.5 0.5

P 2
W 
 
2
0.5K L 0.5 0.5
 
2 P 
1 P 
K L  
1

0.25 W 

So a rise in wage  ___________________

rise in capital stock  __________________
Labor market equilibrium
Take this firm as representative, and sum
over all firms to derive aggregate labor demand.
Combine with labor supply to find equilibrium wage:
W
L 
0.5
demand
demand: 0.5K 0.5

P
supply: Lsupply  L
equilibrium: _____________

So rise in labor supply  _________________

MPL and the demand for labor
Units of labor _____
output
Each firm hires labor
up to the point where
 MPL = W/P
____
____

MPL, Labor
decreasing
______
L Units of labor, L
The firm decides how much capital to rent in the same way it decides
how much labor to hire. The marginal product of capital, or MPK,
is the amount of extra output the firm gets from an extra unit of
capital, holding the amount of labor constant:
MPK = F (K + 1, L) – F (K, L).
Thus, the MPK is the difference between the amount of output produced
with K+1 units of capital and that produced with K units of capital.
Like labor, capital is subject to diminishing marginal product.
The increase in profit from renting an additional machine is the extra
revenue from selling the output of that machine minus the machine’s
rental price:  Profit =  Revenue -  Cost = (P × MPK) – R.
To maximize profit, the firm continues to rent more capital until the MPK
falls to equal the real rental price, MPK = R/P.
The real rental price of capital is the rental price measured in units of
goods rather than in dollars. The firm demands each factor of production
until that factor’s marginal product falls to equal its real factor price.
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.
Total income is divided among the returns to labor, the returns to capital,
and economic profit.
How large is economic profit? If the production function has the property
of constant returns to scale, then economic profit is zero. This conclusion
follows from Euler’s theorem, which states that if the production function
has constant returns to scale, then
F(K,L) = (MPK × K) + (MPL × L)
If each factor of production is paid its marginal product, then the sum
of these factor payments equals total output. In other words, constant
returns to scale, profit maximization,and competition together imply that
economic profit is zero.
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
Paul Douglas 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:

Capital Income = MPK × K = αY

Labor Income = MPL × L = (1- α) Y
 Capital Income = MPK × K = α Y
Labor Income = MPL × L = (1- α) Y

α is a constant between zero and one and

Production Function measures capital and labors’ share of income.
Cobb-Douglas

Cobb showed that the function with this property is:

F (K, L) = A Kα L1- α
A is a parameter greater than zero that
measures the productivity of the
available technology.
Next, consider the marginal products for the Cobb–Douglas
Production function. The marginal product of labor is:
α –α
MPL = (1- α) A K L or, MPL = (1- α) Y / L

and the marginal product of capital is:

MPL = α A Kα-1L1–α or, MPK = α Y/K

Let’s now understand the way these equations work.

Cobb–Douglas production function example
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.

Next, consider the marginal products for the Cobb–Douglas

production function. The MPL :
MPL = (1- α)Y/L
MPK= α A/ K
The MPL is proportional to output per worker, and the MPK is
proportional to output per unit of capital. Y/L is called average
labor productivity, and Y/K is called average capital
productivity. If the production function is Cobb–Douglas, then
the marginal productivity of a factor is proportional to its average
productivity.
An increase in the amount of capital raises the MPL and
reduces the MPK. Similarly, an increase in the parameter

MPL = (1- α) A Kα L–α or, MPL = (1- α) Y / L

and the marginal product of capital is:

MPL = α A Kα-1L1–α or, MPK = α

 Financial markets
The loanable funds model
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
First, rewrite the national income accounts identity as Y - C - G = I.
The term Y - C - G is the output that remains after the demands of
consumers and the government have been satisfied; it is called national
saving or simply, saving (S). In this form, the national income accounts
identity shows that saving equals investment.
To understand this better, let’s split national saving into two parts-- one
examining the saving of the private sector and the other representing
the saving of the government.
(Y - T - C) + (T - G) = I
The term (Y - T - C) is disposable income minus consumption, which is
private saving. The term (T - G) is government revenue minus
government spending, which is public saving. National saving is the
sum of private and public saving.
 To see how the interest rate brings financial markets into equilibrium,
substitute the consumption function and the investment function into
the national income accounts identity:
Y - c(Y - T) - G = I(r)
Next, note that G and T are fixed by policy and Y is fixed by the factors
of production and the production function: Y - c(Y - T) - G = I(r)
S = I(r)
Real
interest Saving, S The vertical line represents
rate, r saving-- the supply of loanable
funds. The downward-sloping
Equilibrium line represents investment--the
interest demand for loanable funds.
rate The intersection determines the
equilibrium interest rate.

Desired Investment, I(r)

S Investment, Saving, I, S
But is the financial
market really this
simple?

Of course
not!!!
The model presented in this chapter represents the economy’s financial system with a single
market– the market for loanable funds. Those who have some income they don’t want to
consume immediately bring their saving to this market. Those who have investment projects
they want to undertake finance them by borrowing in this market. The interest rate adjusts to
bring saving and investment into balance. The actual financial system is a bit more complicated
than this description. As in this model, the goal of the system is to channel resources from savers
into various forms of investment. Two important markets are those of bonds and stocks. Raising
investment funds by issuing bonds is called debt finance, and raising funds by issuing stock is
called equity finance. Another part of the financial markets is the set of financial intermediaries
(i.e. banks, mutual funds, pension funds, and insurance companies) through which households
can indirectly provide resources for investment.
In 2008, the world financial system experienced a historic crisis. Many banks made loans to many
homeowners called mortgages, and had purchased many mortgage-backed securities (financial
instruments whose value derives from a pool of mortgages). A large decline in house prices
throughout the U.S., however, caused many homeowners to default on their mortgages, which
in turn led to large losses at these financial institutions. Many banks and other intermediaries
found themselves nearly bankrupt, and the financial system started having trouble performing
its key functions.
For our purposes of this course , and as a building block for further analysis, representing the
entire financial system by a single market for loanable funds is a useful simplification.
 An Increase in Government Purchases: If we increase government
purchases by an amount G, the immediate impact is to increase the
demand for goods and services by G. But since total output is fixed
by the factors of production, the increase in government purchases must
be met by a decrease in some other category of demand. Because
disposable Y-T is unchanged, consumption is unchanged. The increase
in government purchases must be met by an equal decrease in investment.
To induce investment to fall, the interest rate must rise. Hence, the rise
in government purchases causes the interest rate to increase and investment
to decrease. Thus, government purchases are said to crowd out investment.

A Decrease in Taxes: The immediate impact of a tax cut is to raise disposable

income and thus to raise consumption. Disposable income rises by DT, and
consumption rises by an amount equal to DT times the MPC. The higher the MPC,
the greater the impact of the tax cut on consumption. Like an increase in
government purchases, tax cuts crowd out investment and raise the interest rate.
National saving S, which equals Y - C -G, falls by the same amount as consumption
rises. The saving shifts the supply of loanable funds to the left.
 Real A reduction in saving, possibly the
interest S' Saving, S result of a change in fiscal policy,
rate, r shifts the saving schedule to the left.
The new equilibrium is the point at
which the new saving schedule crosses
the investment schedule. A reduction
in saving lowers the amount of
investment and raises the interest rate.
Desired Investment, I(r)
S Investment, Saving, I, S
Fiscal policy actions are said to crowd out investment.
 Real An increase in the demand for
interest Saving, S investment goods shifts the investment
rate, r schedule to the right. At any given
interest rate, the amount of investment
is greater. The equilibrium moves
B from A to B. Because the amount
of saving is fixed, the increase in
A I2 investment demand raises
I1 the interest rate while leaving
the equilibrium
S Investment, Saving, I, S amount of investment
Now let’s see what happens to the interest unchanged.
rate and saving when saving depends on the
interest rate (upward-sloping saving (S) curve).
 S(r)
Real
interest
rate, r Upward-sloping savings

B
A I2
I1
Investment, Saving, I, S
When saving is positively related to the interest rate, as shown by
the upward-sloping S(r) curve, a rightward shift in the investment
schedule I(r), increases the interest rate and the amount of
investment. The higher interest rate induces people to increase
saving, which in turn allows investment to increase.
 The special role of r
r adjusts to equilibrate the goods market and the loanable funds (L.F)
market simultaneously:
If L.F. market is in equilibrium, then
Y – C – G = I i.e savings = investments
Add (C +G ) to both sides to get
Y = C + I + G (goods market eq’m)
Thus,
Eq’m in
L.F. market  Eq’m in goods
market
Algebra example
Suppose an economy characterized by:
• Factors market supply:
• labor supply= 1000
• Capital stock supply=1000
• Goods market supply:
• Production function: Y = 3K + 2L
• Goods market demand:
• Consumption function: C = 250 + 0.75(Y-T)
• Investment function: I = 1000 – 5000r
• G=1000, T = 1000
Algebra example continued
Given the exogenous variables (Y, G, T), find the
equilibrium values of the endogenous variables (r, C, I)
Find r using the goods market equilibrium condition:

Y=C+I+G
5000 = 250 + 0.75(5000-1000) +1000
-5000r + 1000
5000 = 5250 – 5000r
__________________________so r = _____

And I = 1000 – 5000*(0.05) = ______

C = 250 + 0.75(5000 - 1000) = ______
summary
The real interest rate adjusts to equate
the demand for and supply of
 goods and services

loanable funds: A decrease in national saving causes

the interest rate to rise and investment to fall.
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