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Date Created: 10/03/15
CHAPTER THREE National Income Where it Comes From and Where it Goes what determines the economy s total outputincome howthe prices ofthe factors ofproduction are determined how total income is distributed what determines the demand for goods and services 39 how equilibrium in the goods market is achieved Outline of model A closed economy marketcleanly model Supply side 0 factor markets supply demand price 0 determination of outputincome Demand side 0 determinants of C I and G r o goods market 0 loanable funds market The supply side The production function Y F K 1 K capital L labor F reflects the level of technology exhibits constant returns to scale Determining output If technology and input supply is fixed Output is determined by the fixed factor supplies and the fixed state of technology y RE 2 Distribution of national income NarArIav w nornlnal Wage prlce ofL R nornlnal rental rate prlce of K P price of output WP real Wage measured ll l ul llB ofoutput RP real rental rate Income distribution depends on factor prices Supply of each factor is fixed What about demand Demand for labor Assume markets are competitive rm takes W R and P as given Firm solves MaxPFIl WI RI Optimality candi an PMPI W PL ExtIa output the rm can produce using an additional unit of labor holding other 39npuE xed L FIL1 e FIL The MPL and the production function Y output F7L MPL As more39 labor39 is added 39MPL diminishing returns L MPL JSQIopeVof39ihe produetion functlon equals Ia bor MPL and the demand for labor MPL Labor demand Uniis of labor L Determining the rental rate Capital demand The MPKcune is the rm39s demand white for renting capital Firms maximize pro is by choosing K such that MPK RP How is income distributed W total labor Income 7 MPLgtlt I R total capital Income Fl MPKgtlt I If production function has constant returns to scale 7 MPLgtltZ MPKx7 The demand side Demand for goods amp services Aggregate demand C 1 G Consumption I def disposable income Y T I Consumption function I L Y T Ny T 2 Tc Investment I The invstment function is I r r real interest rate I The ral interest rate is 0 the cost of borrowing 0 the opportunity cost ofusing one39s own funds to nance investment spending Government spending G G includes government spending on goods and services G excludes transfer payments Assume government spending and total taxes are exogenous 05 and 77 Eguilibrium market for goods amp services o Agg demand C777TIrE o Agg supply 7 F7Z o Equilibrium 7 C77TIrE Different interpretation of the same model different way of rewriting the same equations Asimple supplydemand model of the nancial system One asset loanable fundsquot demand for funds investment supply of funds saving price of funds real interest rate THE LOANABLE FUNDS MARKET Demand for funds Investment The demand for loanable funds coms from investment Firms borrow to nance spending on plant amp equipment new of ce buildings etc Consumers borrow to buy new houses epends negatively on r the price of loanable funds the cost of borrowing to lr Supply of funds Saving The supply of loanable funds comes from saving Households use saving to make bank deposits purchase bonds and other assets Funds become available to firms to borrow to finance investment spending 0 The government may also contribute to saving if it does not spend all of the tax revenue it receives Types of saving private saving Y T C public saving T G national saving S private saving public saving Ls IY 5 Public Saving US Federal Govt Budget TG budget surplus of GDP TG asa ofGDP 42 194D 195D 196D 197D 198D 199D ZEIEIEI Loanable funds market equilibrium 377c077 ra Equilibrium real interest rate r s I Equilibrium level of investment The special role ofr r adjusts to equilibrate the goods market w the loanable funds market simultaneously If LF market in equilibrium then Y C G I Add CG to both sides to get Y C I G goods market 9th Thus Mastering the loanable funds model 1 Factors shifting the saving curve public sav39ng i preferences ii tax laws that affect saving 2 Factors shifting the investment curve a Technological innovations b tax laws CASE STUDY The Reagan De cits I Reagan policies during early 19805 increases in de ense spending AGgt 0 big tax cuts ATlt 0 I According to our model both policies reduce national saving 377C7777E The Reagan de cits cont 22 r2 r1 4 r 1 11 51 Are the data consistent with these results variable 19705 19805 T G 22 39 5 196 174 r 11 63 I 199 194 TrG s andlarz expressed as a percent ufGDP All gures are averages aver me decade Shawn Saving and the interest rate I Why might saving depend on r I How would the results of an increase in investment demand be different Would r rise as much Would the equilibrium value of I change An increase in investment demand when saving depends on the interest rate Real intaest rate r 30 1 An increase in desired 2 mm the mterest I rate investmentquot 3and m equilibrium and mv mg 1565 nvextmem 12 I 1 gt InvestmmL Savmg I S