macro

CHAPTER THREE

National Income:
Where it Comes From
and Where it Goes

macroeconomics
fifth edition

N. Gregory Mankiw
PowerPoint Slides
by Ron Cronovich
2002 Worth Publishers, all rights reserved

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 2

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 3

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.

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National Income

slide 4

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 5

Assumptions of the model

1. Technology is fixed.
2. The economys supplies of capital

and labor are fixed at

K K

CHAPTER 3

and

National Income

LL

slide 6

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

Y F (K , L)

CHAPTER 3

National Income

slide 7

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 8

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 9

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

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= marginal product of

National Income

slide 10

Exercise: compute & graph MPL

L
0
value of L
1
b. Graph the production
2
function
3
c. Graph the MPL curve with
4
MPL on the
5
vertical axis and
6
L on the horizontal axis
7
d. Dim. Marginal Productivity
8
9
10
a. Determine MPL at each

CHAPTER 3

National Income

Y MPL
0 n.a.
10
?
19
?
27
8
34
?
40
?
45
?
49
?
52
?
54
?
55
?
slide 11

answers:
Marginal Product of Labor
MPL (units of output)

Output (Y)

Production function
60
50
40
30
20
10

12
10
8
6
4
2
0

0
0

9 10

Labor (L)

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National Income

9 10

Labor (L)

slide 12

The MPL and the production

function
Y
output
F (K , L)
MP
1 L

As more labor
is added, MPL

MP
1 L
MP
L
1

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Slope of the
production function
equals MPL

National Income

L
labo
r

slide 13

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 14

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 .

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National Income

slide 15

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 )

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National Income

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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 17

The consumption function

C

C (Y
T)

MPC
1

The slope of the

consumption
function is the
MPC.
YT

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National Income

slide 18

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 19

The investment function

r

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

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National Income

slide 20

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

G excludes transfer payments

Assume government spending and
total taxes are exogenous:

G G

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and

National Income

T T

slide 21

The market for goods & services

Agg. demand:
Agg. supply:
Equilibrium:

C (Y T ) I (r ) G
Y F (K , L)
Y = C (Y T ) I (r ) G

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

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National Income

slide 22

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

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National Income

slide 23

Loanable funds demand curve

r

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

slide 24

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.
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National Income

slide 25

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

T G

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

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TG

C G

National Income

slide 26

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.

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National Income

slide 27

The U.S. Federal Government Budget

44

GDP
%%ofofGDP

00

-4-4

(T
(T-G
-G))as
asaa%
% of
ofGDP
GDP

-8-8

-12
-12
1940
1940

1950
1950

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1960
1960

1970
1970

National Income

1980
1980

1990
1990

2000
2000

slide 28

The U.S. Federal Government Debt

Fun
Funfact:
fact: In
Inthe
theearly
early1990s,
1990s,
nearly
nearly18
18cents
centsof
ofevery
everytax
tax
dollar
dollarwent
wentto
topay
payinterest
intereston
on
the
thedebt.
debt.
(Today
(Todayits
itsabout
about99cents.)
cents.)

120
120

PercentofofGDP
GDP
Percent

100
100
80
80
60
60
40
40
20
20
00
1940
1940
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1950
1950

1960
1960

1970
1970

National Income

1980
1980

1990
1990

2000
2000

slide 29

Loanable funds supply curve

r

S Y C (Y T ) G

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

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National Income

slide 30

Loanable funds market equilibrium

r

S Y C (Y T ) G

Equilibrium real
interest rate

I (r )
Equilibrium level
of investment
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National Income

S, I

slide 31

Mastering the loanable funds model

1. Things that shift the saving curve
a. public saving
i. fiscal policy: changes in G or T
b. private saving
i. preferences
ii. tax laws that affect saving

401(k)
IRA
replace income tax with
consumption tax

CHAPTER 3

National Income

slide 32

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:
S Y C (Y T ) G

G S
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National Income

T C S
slide 33

1. The Reagan deficits, cont.

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

S1

r2
r1

3. which reduces
the level of
investment.
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S2

National Income

I (r )
I2

I1

S, I
slide 34

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 35

Mastering the loanable funds model

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

firms must buy new investment

goods
b. tax laws that affect investment
investment tax credit

CHAPTER 3

National Income

slide 36