CHAPTER-3:

N AT I O N A L I N C O M E : W H E R E I T C O M E S
FROM AND WHERE IT GOES

C O U R S E T E AC H E R :
D R . TA M G I D A H M E D C H OW D H U RY
A S S O C I AT E P R O F E S S O R , S B E
OBJECTIVES OF THE CHAPTER
• After completing this chapter, students will be able to understand:
- What determines the national income of the country?
- How much of the national income is contributed by the firms?
- What are the different groups in economy who make purchases? How are
those purchases calculated?
- How economy reaches to the equilibrium where spending on consumption,
investment by groups, and government purchase equals the level of
production?
NATIONAL INCOME
It is the total income of the nation earned from nation’s total output of goods
and services in a specific year. The most important measure of national
income is GDP and GNP.
The macro-economy involves three types of markets:
1. Goods (and services) Market
2. Factors Market or Labor market , needed to produce goods and services
3. Financial market
Are also four types of agents in an economy:
1. Households
2. Firms
3. Government
4. Rest of the world
CIRCULAR FLOW OF NATIONAL INCOME:
REVISITED

Question: In the
Diagram, among A,
B, C, and D, which
transaction is
beneficial for the
country?
TOTAL PRODUCTION OF GOODS AND SERVICES: SUPPLY
SIDE ANALYSIS
Supply in the goods market depends on a production function:
denoted Y = F (K, L)
Where
K = capital: tools, machines, and structures used in production
L = labor: the physical and mental efforts of workers
• Generally, we will assume it exhibits constant returns to scale. This means
change in output is proportional to change in input. Mathematically:
zY = F (zK, zL)
• However, the production process may also exhibit increasing and decreasing
returns to scale. For example:
- Labor and capital have been doubled but output is more than doubled
(increasing scale): 3Y = F (2K, 2L)
- Labor and capital have been doubled but output is less than doubled
(decreasing scale): 1.5Y = F (2K, 2L)
DETERMINING GDP/NATIONAL INCOME

Output is determined by the fixed factor supplies and the fixed state
of technology:
So we have a simple initial theory of supply in the goods market:

Y  F (K , L )
GOODS AND SERVICE MARKET: DEMAND SIDE
ANALYSIS
Components of aggregate demand: Y = C + I + G
C = consumer demand for g & s
I = demand for investment goods
G = government demand for g & s

(closed economy: no NX )

For open economy:

Y = C + I + G + NX
CONSUMPTION (C)
• def: disposable income is total income minus total taxes: Y–T
• Consumption function: The relation between consumption and disposable
income.
C = C (Y – T )
Shows that (Y – T )  C
• def: The marginal propensity to consume (MPC) is the increase in C
caused by an increase in disposable income.
• So MPC = derivative of the consumption function with respect to disposable
income. Mathematically: MPC = dC/dY. This equation justifies that MPC is
the slope of the consumption curve.
• MPC must be between 0 and 1. MPC = 0.70 means that households spend 70%
of their income on consumption.
CONSUMPTION FUNCTION

C Consumption curve has a vertical

intercept which means there is at least
some level of consumption even though
C ( Y –T ) income is zero. This is called autonomous
consumption.

Suppose consumption function:

The slope of the
C=10 + 0.75Y
rise consumption
MPC = 0.75
function is the MPC.
run For extra dollar of income, spend 0.75
dollars consumption

Marginal propensity to save = 1-MPC

Y–T
CONSUMPTION AND DISPOSABLE INCOME:
BANGLADESH CASE
INVESTMENT (I)
• the action or process of investing money (or even time) for profit.
• 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
 INVESTMENT CURVE The demand for loanable funds:
•comes from investment:
Firms borrow to finance
r Spending on investment spending on plant &
goods equipment, new office
is a downward-sloping buildings, etc. Consumers
function of the real borrow to buy new
interest rate houses.
•depends negatively on r ,
the “price” of loanable
funds (the cost of
borrowing).
I (r )

I
 TREND OF INVESTMENT IN BANGLADESH

Chart Title
35

30

2012-13 2013-14 2014-15

25

Growth of Private Inv 9.81 13.54 12.84

20

Growth of Public Inv 30.92 10.43 18.77

15

Growth of total Inv 14.12 12.81 14.2

10

Inv as % of GDP 28.38 28.57 28.97

5

0
2012-13 2013-14 2014-15

Growth of Private Inv Growth of Public Inv Growth of total Inv Inv as % of GDP
GOVERNMENT PURCHASES
• G includes government spending on goods and services.
• G excludes transfer payments
• Assume government spending and total taxes are exogenous:

G G and T T
• 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.
GOVERNMENT SPENDING, BUDGET DEFICIT, AND DEBT:
BANGLADESH CASE
EQUILIBRIUM IN GOODS AND SERVICE MARKET

 Agg. demand: C (Y  T )  I (r )  G
 Agg. supply: Y  F (K , L )
 Equilibrium: Y = C (Y  T )  I (r )  G

The real interest rate adjusts

to equate demand with supply.
FIRM’S DEMAND FOR FACTOR: HOW THEY
DECIDE
Analyze the decision of a typical competitive firm.
• It buys labor in the labor market, where price is wage, W.
• It rents capital in the factors market, at rate R.
• It uses labor and capital to produce the good, which it sells in the goods market, at
price P.
The firm chooses the optimal quantity of Labor and capital to maximize its profit.
How to calculate profit:
Profit = revenue - labor costs - capital costs
= PY - WL - RK
= P F(K,L) - WL - RK
CHOOSING THE RIGHT AMOUNT OF LABOUR
Y = output
• More labour will add more output
but more cost too. Firm will thus F (K , L )
analyse the marginal productivity MPL
of labour MPL. 1
As more labor is
• MPL is the extra output the firm
MPL added, MPL 
can produce using one additional
labor (holding other inputs fixed): 1

MPL = F (K, L +1) – F (K, L)

Slope of the production
MPL = dY/dL MPL
function equals MPL: rise over
• In general firms experience run
diminishing marginal product of 1
labor L
labor
MATHEMATICAL CALCULATION OF MPL
1
Y
2)Y  F (L )  3L  3 L
2

9
1
Y 1 1
 fL  3  L 2 6
L 2
1 3
3 2 3
 L 
2 2 L 1 4 9 L

L: 1 4 9
F(L): 3 6 9
fL: 1.5 0.75 0.5
RETURN TO THE FIRM’S PROBLEM: CHOOSING
THE RIGHT AMOUNT OF LABOUR
Firm chooses L to maximize its profit.
How will increasing L change profit?
D profit = D revenue - D cost = D (P * Q) - D cost
= P * MPL - W (note: here Q is the extra output produced by extra labor thus MPL)
If this is: >0 should hire more
<0 should hire less
=0 hiring right amount
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:
MPL = W/P, where W/P is the ‘real wage’
Mathematical note: Assume bread price is 2 Taka and a worker earns 20 Taka/hour. Real wage is
20/2 = 10 breads/hour. This bakery should continue hiring as long as additional worker can
produce 10 breads/hour.
CONSIDERING M PL IN HIRING DECISION

• Considering the marginal

contribution of the laborer,
this firm will hire up to 7
workers. More employment
will create a negative
contribution by the additional
workers.
CHOOSING THE RIGHT AMOUNT OF CAPITAL
D profit = D revenue - D cost = D (P * Q) - D cost
= P * MPK - R (note: here Q is the extra output produced by extra Capital thus MPK)
If this is: >0 should use more
<0 should use less
=0 right amount of capital
So the firm’s demand for labor is determined by the condition:
P *MPK = R
Hires more and more K, until MPK falls enough to satisfy the condition.
Also may be written:
MPK = R/P, where R/P is the ‘real rental price of capital’

Firm’s decision criterion: The firm’ demands each factor of production until that factor’s marginal
product falls to equal to its real factor price (such as, real wage or real rental price).
 EQUILIBRIUM IN THE FACTORS MARKET
• Equilibrium is where factor supply equals Factor supply
factor demand.
Factor
• Factor prices are the amounts paid to the price
factors of production and this is determined

by factor demand and factor supply.
Equilibrium
• Supply of factors is fixed (thus a perfectly factor price
vertical supply curve).
• Demand for factors comes from firms. Higher 
factor price will lower the demand for factors Factor demand
as firms have fixed investment capital. This
makes the factor demand curve downward
slopping. Quantity of factor
SUPPLY OF LOANABLE FUNDS: SAVINGS
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.
• private saving (sp) = (Y –T ) – C

• government saving (sg) = T – G

• national saving, S
= sp + sg
= (Y –T ) – C + T–G
= Y – C – G = I (r) (Note: Y = C + I + G)
= S = I(r)
TREND OF SAVINGS IN BANGLADESH
SAVINGS, INVESTMENT AND THE INTEREST RATE

r S  Y  C (Y  T )  G

National saving
does not
depend on r,
Equilibrium real
so the supply
interest rate
curve is
vertical.
I (r )
Equilibrium level S, I
of investment
CHANGE IN SAVINGS AND EFFECTS IN THE MARKET

1. The increase in r S1
S2
the deficit
reduces saving…

r2
2. …which causes
the real interest
r1
rate to rise…

3. …which reduces I (r )
the level of I2 I1 S, I
investment.
MATHEMATICAL EXAMPLE OF NATIONAL
INCOME ACCOUNTING
Suppose an economy characterized by:
• Factors market supply:
– labor supply= 1000 Find the equilibrium values
of the endogenous
– Capital stock supply=1000
variables (r, C, I)
• 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
SOLUTION TO THE PROBLEM
Find r using the goods market equilibrium condition:

Y=C+I+G
5000 = 250 + 0.75(5000-1000) +1000
-5000r + 1000
5000 = 5250 – 5000r
-250 = -5000r so r = 0.05

And I = 1000 – 5000*(0.05) = 750

C = 250 + 0.75(5000 - 1000) = 3250
PRACTICE PROBLEM
• Consider an economy as described by the following equations:
Y=C+I+G
Y = 5000
G = 1000
T = 1000
C = 250 + 0.75 (Y - T)
I = 1000 – 5000r
a) Compute private saving, public saving, and national saving
b) Find the equilibrium interest rate
c) Now suppose that G rises to 1250. Compute private saving, public saving, and national saving
d) Find the new equilibrium interest rate