CHAPTE

National Income:
Where it Comes From
and Where it Goes

MACROECONOMICS SIXTH EDITION

N. GREGORY MANKIW
PowerPoint Slides by Ron Cronovich
2007 Worth Publishers, all rights reserved

In this chapter, you will

learn

what determines the economys total

output/income

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 2

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 3

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 4

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

CHAPTER 3 National Income

slide 5

Returns to scale: A review

Initially Y1 = F (K1 , L1 )
Scale all inputs by the same factor z:
K2 = zK1 and L2 = zL1
(e.g., 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 6

Example 1
F (K , L)

KL

F (zK , zL)

(zK )(zL)

z 2KL

z 2 KL

z KL
z F (K , L)
CHAPTER 3 National Income

constant returns to
scale for any z > 0
slide 7

Example 2
F (K , L)

K L

F (zK , zL)

zK zL

z K z L

K L

z F (K , L)

CHAPTER 3 National Income

decreasing
returns to scale
for any z > 1
slide 8

Example 3
F (K , L) K 2 L2
F (zK , zL) (zK )2 (zL)2
z 2 K 2 L2

z F (K , L)
2

CHAPTER 3 National Income

increasing returns
to scale for any
z>1

slide 9

Now you try

Determine whether constant, decreasing, or

increasing returns to scale for each of these
production functions:
K2
(a) F (K , L)
L
(b) F (K , L) K L

CHAPTER 3 National Income

slide 10

Answer to part (a)

2

K
F (K , L)
L

(zK )2
F (zK , zL)
zL
z 2K 2

zL
K2
z
L
z F (K , L)
CHAPTER 3 National Income

constant returns to
scale for any z > 0
slide 11

Answer to part (b)

F (K , L) K L
F (zK , zL) zK zL
z (K L)

z F (K , L)

CHAPTER 3 National Income

constant returns to
scale for any z > 0

slide 12

Assumptions of the model

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

are fixed at

K K

CHAPTER 3 National Income

and

LL

slide 13

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 14

The distribution of national

income

determined by factor prices,

the prices per unit that firms pay for the
factors of production

wage = price of L
rental rate = price of K

CHAPTER 3 National Income

slide 15

Notation
W
W ==nominal
nominalwage
wage
RR ==nominal
nominalrental
rentalrate
rate
PP ==price
priceofofoutput
output
W
W/P
/P ==real
realwage
wage
(measured
(measuredininunits
unitsofofoutput)
output)
RR/P
/P ==real
realrental
rentalrate
rate

CHAPTER 3 National Income

slide 16

How factor prices are

determined

Factor prices are determined by supply and

demand in factor markets.

Recall: Supply of each factor is fixed.

What about demand?

CHAPTER 3 National Income

slide 17

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 = marginal product of labor

CHAPTER 3 National Income

slide 18

Marginal product of labor

(MPL )

definition:
The extra output the firm can produce
using an additional unit of labor
(holding other inputs fixed):
MPL = F (K, L +1) F (K, L)

CHAPTER 3 National Income

slide 19

Exercise: Compute & graph

MPL
a. Determine MPL at each
value of L.
b. Graph the production
function.
c. Graph the MPL curve with
MPL on the vertical axis
and
L on the horizontal axis.

CHAPTER 3 National Income

L
0
1
2
3
4
5
6
7
8
9
10

Y
0
10
19
27
34
40
45
49
52
54
55

MPL
n.a.
?
?
8
?
?
?
?
?
?
?
slide 20

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)

CHAPTER 3 National Income

9 10

Labor (L)

slide 21

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

CHAPTER 3 National Income

Slope of the
production function
equals MPL

L
labo
r

slide 22

Diminishing marginal returns

As a factor input is increased,

its marginal product falls (other things equal).

Intuition:
Suppose L while holding K fixed
fewer machines per worker
lower worker productivity

CHAPTER 3 National Income

slide 23

Check your understanding:

Which of these production functions have

diminishing marginal returns to labor?

a) F (K , L) 2K 15L
b) F (K , L)

KL

c) F (K , L) 2 K 15 L

CHAPTER 3 National Income

slide 24

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 25

MPL and the demand for labor

Units of
output

Each
Eachfirm
firm hires
hires labor
labor
up
upto
tothe
thepoint
pointwhere
where
MPL
MPL== W/P.
W/P.

Real
wage

MPL,
Labor
demand
Units of labor, L
Quantity of labor
demanded
CHAPTER 3 National Income

slide 26

The equilibrium real wage

Units of
output

Labor
supply

equilibrium
real wage
L

CHAPTER 3 National Income

The
Thereal
realwage
wage
adjusts
adjuststo
toequate
equate
labor
labor demand
demand
with
withsupply.
supply.

MPL,
Labor
demand
Units of labor, L

slide 27

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 .

CHAPTER 3 National Income

slide 28

The equilibrium real rental rate

Units of
output

Supply of
capital

equilibrium
R/P
K

CHAPTER 3 National Income

The
Thereal
realrental
rentalrate
rate
adjusts
adjuststo
to equate
equate
demand
demandfor
forcapital
capital
with
withsupply.
supply.

MPK,
demand for
capital
Units of capital, K

slide 29

The Neoclassical Theory

of Distribution

states that each factor input is paid its marginal

product

is accepted by most economists

CHAPTER 3 National Income

slide 30

How income is distributed:

W
L MPL L
total labor income =
P
R
K MPK K
total capital income =
P

If production function has constant returns to

scale, then

Y MPL L MPK K
national
income
CHAPTER 3 National Income

labor
income

capital
income
slide 31

The ratio of labor income to total

income in the U.S.
Labors
share
of total
income

Labors
Labors share
share of
of income
income
is
is approximately
approximately constant
constant over
over time.
time.
(Hence,
(Hence, capitals
capitals share
share is,
is, too.)
too.)

CHAPTER 3 National Income

slide 32

The Cobb-Douglas Production

Function

The Cobb-Douglas production function has

constant factor shares:

= capitals share of total income:

capital income = MPK x K = Y
labor income = MPL x L = (1 )Y

The Cobb-Douglas production function is:

Y AK L1
where A represents the level of technology.
CHAPTER 3 National Income

slide 33

The Cobb-Douglas Production

Function

Each factors marginal product is proportional to

its average product:

Y
MPK AK L
K
(1 )Y

MPL (1 ) AK L
L
1 1

CHAPTER 3 National Income

slide 34

Outline of model
A closed economy, market-clearing model
Supply side
factor markets (supply, demand, price)
DONE
DONE
determination of output/income
Demand side
Next determinants of C, I, and G
Equilibrium
goods market
loanable funds market
CHAPTER 3 National Income

slide 35

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 )

CHAPTER 3 National Income

slide 36

Consumption, C
def: Disposable income is total income minus
total taxes:

Y T.

Consumption function: C = C (Y T )
Shows that (Y T ) C

def: Marginal propensity to consume (MPC)

is the increase in C caused by a one-unit
increase in disposable income.

CHAPTER 3 National Income

slide 37

The consumption function

C

C (Y T )

MPC
1

The slope of the

consumption function
is the MPC.

YT
CHAPTER 3 National Income

slide 38

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 39

The investment function

r

Spending on
investment goods
depends negatively on
the real interest rate.

I
(r )
I
CHAPTER 3 National Income

slide 40

Government spending, G

G = govt spending on goods and services.

G excludes transfer payments
(e.g., social security benefits,
unemployment insurance benefits).

Assume government spending and total taxes

are exogenous:

G G

CHAPTER 3 National Income

and

T T

slide 41

The market for goods &

services

Aggregate demand:
Aggregate supply:
Equilibrium:

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

The real interest rate adjusts

to equate demand with supply.
CHAPTER 3 National Income

slide 42

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

CHAPTER 3 National Income

slide 43

Demand for funds:

Investment
The demand for loanable funds

comes from investment:

Firms borrow to finance spending on plant &
equipment, new office buildings, etc.
Consumers borrow to buy new houses.

depends negatively on r,
the price of loanable funds
(cost of borrowing).

CHAPTER 3 National Income

slide 44

Loanable funds demand curve

r

The
The investment
investment
curve
curve is
is also
also the
the
demand
demand curve
curve for
for
loanable
loanable funds.
funds.

I
(r )
I
CHAPTER 3 National Income

slide 45

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 the tax revenue it
receives.
CHAPTER 3 National Income

slide 46

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

T G

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

TG

Y C G

CHAPTER 3 National Income

slide 47

Notation: = change in a
variable

For any variable X, X = the change in X

is the Greek (uppercase) letter Delta
Examples:

If L = 1 and K = 0, then Y = MPL.

Y
.
More generally, if K = 0, then MPL
L
(YT ) = Y T , so

MPC (Y T )

= MPC Y MPC T
CHAPTER 3 National Income

slide 48

EXERCISE:

Calculate the change in saving

Suppose MPC = 0.8 and MPL = 20.
For each of the following, compute S :
a. G

= 100

b. T

= 100

c. Y

= 100

d. L = 10

CHAPTER 3 National Income

slide 49

Answers
S Y C G Y 0.8(Y T ) G
0.2 Y 0.8 T G

a. S 100

b. S 0.8 100 80
c. S 0.2 100 20

d. Y MPL L 20 10 200,
S 0.2 Y 0.2 200 40.
CHAPTER 3 National Income

slide 50

digression:

Budget surpluses and deficits

If T > G, budget surplus = (T G )

= public saving.

If T < G, budget deficit = (G T )

and public saving is negative.

If T = G , balanced budget, public saving = 0.

The U.S. government finances its deficit by
issuing Treasury bonds i.e., borrowing.
CHAPTER 3 National Income

slide 51

U.S. Federal Government

Surplus/Deficit, 1940-2004

CHAPTER 3 National Income

slide 52

U.S. Federal Government Debt,

1940-2004

CHAPTER 3 National Income

Fact:
Fact: In
In the
the early
early 1990s,
1990s,
about
about 18
18 cents
cents of
of every
every tax
tax
dollar
dollar went
went to
to pay
pay interest
interest on
on
the
the debt.
debt.
(Today
(Today its
its about
about 99 cents.)
cents.)

slide 53

Loanable funds supply curve

r

S Y C (Y T ) G

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

S, I
CHAPTER 3 National Income

slide 54

Loanable funds market

equilibrium
r

S Y C (Y T ) G

Equilibrium real
interest rate

I (r )
Equilibrium level
of investment
CHAPTER 3 National Income

S, I

slide 55

The special role of r

rr adjusts
adjusts to
to equilibrate
equilibrate the
the goods
goods market
market and
and the
the
loanable
loanable funds
funds market
market simultaneously:
simultaneously:
IfIf L.F.
L.F.market
market in
in equilibrium,
equilibrium, then
then
YY C
C G
G == II
Add
Add (C
(C +G
+G )) to
to both
both sides
sides to
to get
get
YY == C
C ++ II ++ G
G (goods
(goods market
market eqm)
eqm)
Thus,
Thus,

Eqm in L.F.
market

CHAPTER 3 National Income

Eqm in goods
market
slide 56

Digression: Mastering
models
To master a model, be sure to know:
1. Which of its variables are endogenous and
which are exogenous.
2. For each curve in the diagram, know
a. definition
b. intuition for slope
c. all the things that can shift the curve
3. Use the model to analyze the effects of each
item in 2c.
CHAPTER 3 National Income

slide 57

Mastering the loanable funds

model
Things that shift the saving curve
public saving
fiscal policy: changes in G or T

private saving
preferences
tax laws that affect saving
401(k)
IRA
replace income tax with consumption tax
CHAPTER 3 National Income

slide 58

CASE STUDY:

The Reagan deficits

Reagan policies during early 1980s:

increases in defense spending: G > 0
big tax cuts: T < 0
Both policies reduce national saving:
S Y C (Y T ) G

G S

CHAPTER 3 National Income

T C S

slide 59

CASE STUDY:

The Reagan deficits

1.
1. The
The increase
increase in
in
the
the deficit
deficit
reduces
reduces saving
saving
2.
2. which
which causes
causes
the
the real
real interest
interest
rate
rate to
to rise
rise
3.
3. which
which reduces
reduces
the
the level
level of
of
investment.
investment.
CHAPTER 3 National Income

S2

S1

r2
r1
I (r )
I2

I1

S, I
slide 60

Are the data consistent with these

results?

variable

1970s

1980s

TG

2.2

3.9

19.6

17.4

1.1

6.3

19.9

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 61

Now you try

Draw the diagram for the loanable funds model.
Suppose the tax laws are altered to provide more
incentives for private saving.
(Assume that total tax revenue T does not change)

What happens to the interest rate and investment?

CHAPTER 3 National Income

slide 62

Mastering the loanable funds

model, continued
Things that shift the investment curve

some technological innovations

to take advantage of the innovation,
firms must buy new investment goods

tax laws that affect investment

investment tax credit

CHAPTER 3 National Income

slide 63

An increase in investment
demand
r

raises the
interest rate.

r2

An increase
in desired
investment

r1
But the equilibrium
level of investment
cannot increase
because the
supply of loanable
funds is fixed.
CHAPTER 3 National Income

I1

I2

S, I

slide 64

Saving and the interest rate

Why might saving depend on r ?

How would the results of an increase in
investment demand be different?

Would r rise as much?

Would the equilibrium value of I change?

CHAPTER 3 National Income

slide 65

An increase in investment
demand when saving depends
on r
An
An increase
increase in
in
investment
investment demand
demand
raises
raises r,
r,
which
which induces
induces an
an
increase
increase in
in the
the
quantity
quantity of
of saving,
saving,
which
which allows
allows II
to
to increase.
increase.

S (r )

r2
r1
I(r)2
I(r)
I1 I2

CHAPTER 3 National Income

S, I
slide 66

Chapter Summary

Total output is determined by

the economys quantities of capital and labor
the level of technology
Competitive firms hire each factor until its
marginal product equals its price.

If the production function has constant returns to

scale, then labor income plus capital income
equals total income (output).
CHAPTER 3

National Income

slide 67

Chapter Summary

A closed economys output is used for

consumption
investment
government spending
The real interest rate adjusts to equate
the demand for and supply of
goods and services
loanable funds
CHAPTER 3

National Income

slide 68

Chapter Summary

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.

CHAPTER 3

National Income

slide 69