Intermed Macro Theory
Intermed Macro Theory ECN 101
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Date Created: 09/08/15
CHAPTER THREE National Income Where it Comes From and Where it Goes macro In this chapter you will learn what determines the economy s total outputincome 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 CHAPTER 3 National Income slide 1 Outline of model A closed economy marketclearing model Supply side 0 factor markets supply demand price 0 determination of outputincome Demand side 0 determinants of C I and G Eguilibrium o goods market 0 loanable funds market CHAPTER 3 National Income slide 2 Factors of production K II capital tools machines and structures used in production I ll labon 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 re ects the economy s level of technology exhibits constant returns to scale CHAPTER3 National Income sud Returns to scale a review Initially Y1 FK1L1 Scale all inputs by the same factor 2 K2 2K1 and L2 2L1 If 1 125 then all inputs are increased by 25 What happens to output Y2 FKZLZ If constant returns to scale Y2 2Y1 If increasing returns to scale YZ gt 2Y1 If decreasing returns to scale YZ lt 2Y1 CHAPTER3 National Income I slide 5 Assumptions of the model 1 Technology is xed 2 The economy39s supplies of capital and labor are xed at Determining GDP Output is determined by the xed factor supplies and the fixed state of technology KK LL yFE7 cuntka National lnEumE sum amigo Natlunallncume Sim Notation The distribution of national income I determined by factor prices the prices per unit that firms pay for the factors of production I The wage is the price of L the rental rate is the price of K mman National incumE sues w nominal wage n nom39nal rental rate P price of output w P 7 real wage measured in unib of output R P real renml rate mm malurallncume slide10 How factor prices are determined I Factor prices are determined by supply and demand in factor markels I Recall Supply of each factor is xed I What about demand sum Demand for labor IAssume markels are competitive each rm takes W R and P as given I Bas c idea A firm hires each marginal unit of labor if the cost does not exceed the benefit benefit marginal product of labor MAPng Naiurvallncume slide12 cnnmu National lncume Marginal product of labor MPL The extra output the firm can produce using an additional unit of labor holding other inpuls xed MPL FKL 1 FKL CNAPJEKJ National incume no 13 Exercise compute amp graph MPL v MPL 3 Determine MPL at each 39 value of L 0 quota 1 1o b Graoh the produchon 2 19 funchon 3 27 8 c Graoh the MPL curve 4 34 with MPL on the 5 4o vertical as an o 45 L on the horizontal axis 7 49 s 52 9 54 1o 55 gamma paldngllncdme Sm u answers Pmmcnnn tuncnnn Mrgiml product 111 Llhnr WL lunnsm odde 111a MPL and the production function As mare labur is added MDL L d 1 2 a 4 5 a 7 E g u Mm Slnpe dtthe produttdn mot Ll tunttldn eduals MDL L labor CNAfIER Nationallncdme slams Lamina Naymallricdme slaw Diminishing marginal returns As a facmr input is increased its marginal product falls other things equal 39 Intuition TL while holding K fixed fewer machines per worker 2 lower productivity cumgm National incume slidlt7 Check your understanding Which of these production functions have diminishing marginal returns to labor YKL YKL yKu5Lu5 ammo NaIlPVFllncdme slide15 Exercise part 2 Suppose WP o d IfL 3shouid rm hire more or iess labor Why e if L 7 should rm hire more or iess labor Why oowuamszHoi a a o o HNw U OVNOO alumni National income slideiQ MPL and the demand for labor Each irm hires labor up to the point wine MPL wP UnlB oflabori L Quantity of liar demanded our maximal incume awn Determining the rental rate We have just seen that MPL WP The same logic shows that MPK n P diminishing returns to capimi MPKJ as KT K curve is the rm s demand curve for renting capital Firms maximize profits by choosing K ilch that MPK CNAPIERJ National income gram Neoclassical Theory of Distribution mml labor income MPL x L mml capital income MPKxK Euler s theorem implies that ifa production function has constant returns to scale then v MPLx L MPKx K nauonal laser capital income income in me There is no residual economic profitquot i gamma Naiiuriai income siren Outline of model A ciosed economy marketsearly mode Suggly Si pone sfiactor markem Supplv demand price pone of determination of outputincome Demand side Nquot u determinanm of c 1 and s Egulllbi lum u goods market u ioanabie funds market cman National income siiatz Demand for goods amp services Componenls of aggegate demand C sumer demand for g amp s I demand for investment goods 6 government demand for g amp s for now we will assume a closed economy no NX WAFER matiuriaiincume 5mm Consumption C I def disposable income is total income minus total taxes Y T I Consumption function C C Y T Shows that Tv T 2 Tc I def The marginal propensity to consume is the increase in C caused by a oneunit increase in disposable income 01Ame 1 Natinriai incumE The consumption function C CY er The siope otthe MP5 consumption function 1 is th MPC Suez WWW New incur ewe Investment I The investment function The 39nvestmentfunction is I Ir r where r denotes the real interest rate 59mm 0 the nominal interest ram corrected for Name 90 65 is a downward 39quot at39 quot sioping tmctim ot 39 The real interest rate is the reai interest rate the cost of borrowing the opportunity cost of using one s own funds 1039 to nance investment spending So r ewrm Natinriai incume Siam i write Naiiunei incume 5w GOVemmem SPGHdingr G The market for goods amp services I 6 includes government spending on s and services I G excludes transfer payments Y C I I I G I Assume government spending and total taxes are exogenous Y C Y I r G 5 z T T n The real interest rate adjusts to equate demand with supply 7 cwmu Natinriai incume mm mAPIEiU Nahum incume 5mm The loanable funds market A simple supplydemand model of the nancial system One asset loanable funds demand for funds investment supply 0 un s39 sav39ng price39 of funds real interest rate cullme a Natlnnal lncume gram Demand for funds Investment The demand for loanable funds comes from investment Firms borrow to nance saending on plant amp equipment new of ce buildings etc Consumers borrow to buy new houses depends negatively on r the price of loanable funds the cost of borrowing gamma mammal incume slide z Loanable funds demand curv The investment lhe demand cuve for loanable funds CNAPIER a Natmnal lncume e slide 3 Supply of funds Saving The supply of loanable funds comes from saving Households use their saving m make bank borrow to nance investment spending The government may also contribute to saving if it does not spend all of the fax revenue it receives gamma Natural incume all Types of saving private saving Y T C public saving T G national saving S private saving public saving Y T c Y C G cttmm Natiunal lncume greens Notation A change in a variable For any variable x AX the change in xquot A is the Greek uppercase letter Delta Examples IfAL 1 and AK 0 then AY MPL Generally if AK 0 then AY MPL AL Myer AYrAT so MPC x A v7 AT MPC AYr MPC AT alumna Manama lncume sums EXERCI e the ch ange in saying Suppose MPC 08 and MPL 20 For each of the following compute AS 5 A6 100 b AT 100 c AY 100 d AL 10 emu Nannie mum slam digression Budget surplus Sanddefigits When T gt G budget suiplus 176 public saving 6 and public saving is negative 1 G budget is balanced and public saving 0 mer Napunal lncuine siiaeaa The US Federal Government Budget Loanable funds market equilibrium r n Equlllbrlum real lrlterest rate slate i WPW Wrellmum slim The spec39a39 r le f r Mastering the loanable funds model I adjusE to equilibrate the goods market 1 Things mat shift me saving curve the loanable funds market simulmneously a p c 58vquot If LF market in equilibrium then i scal policy changes in s or 1 y c G e 1 b prlvam saving i references Add 0 6 to both sides m get H pm laws mat affect saving Y C 1 G goods market eq m 111k Thus the two conditions are equivalent 39 IRA replace inoome tax With conilmption mx CEW39EU nal meme slate l WWW New WW slam CASE STUDY The Reagan De cits 39 39 39 19805 9 increases in defense soend39ng AG gt o 9 big mx cue AT lt 0 According to our model both policies reduce national saving cmma Natlnriai lncume slaw l The increase in 2 which causes the real interest te u rise The Reagan deficits cont the deticit reduces saving rat which reduces the level at investment 91 ng Natiunai lncume SM Are the dam consistent with these result variable 19705 19805 T G 22 39 S 196 174 r 11 63 I 199 194 LG s andare Exprexxed a a percent afGDP All gwe are average aw the decade hawn CNAPIER a Natlnriai lncume Shaun Mastering the loanable funds model 2 Things that shi the investment curve a certain technological innovations o e advanmge of the 39nnovation rms must buy new investment goods b mx laws that affect 39nvestment 39 estmmtmx credit pmnga Natiunai incume siide4 An increase in investment demand An increase in desired raises he investment interest rate r 2 r1 But lne equllbrlum level orinvestrnenl cannot increase because lne suppy ofoanabe 5 1 fund is fixed crimson Nahuriai income 5 Saving and the interest rate Why might saving depend on r How would the resule of an increase in investment demand be different Woul r rise as muc 7 Would the equilibr39um value of 1 change WAFER matiunailncume siide Chapter summary Chapter summary 4 The economy s output is used for 1 Tomi output is determined by how much capital and labor the economy has consumption the level orremnology which depends on diqaosable income inves men 2 Competitive rms hire each factor until is depends on me real hmresnate magnal product equals its pnce ovemment wequot mg 3 If the production function has constant returns gem m scale then labor income plus capital income 5 The real inmrest rate adesE m equam equals total income output die demmd for and imply of goo s an services loanable funds cman Natlnnal lncume sum gamma mammal incume W52 Chapter summary A decrease in national saving causes the interest ram to rise and hvestment to fall An increase in investment demand causes the interest ram m rise but does not affect the equilibrium level of inv stment if the svpply of loanable funds is xed slats of an Natlunallncume 5M5 PMPIERJ Mallurlallrlcume
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