Macroeconomics

N. Gregory Mankiw

National Income:
Where it Comes
From and Where It
Goes
Presentation Slides

© 2019 Worth Publishers, all rights reserved

 IN THIS CHAPTER, YOU WILL LEARN:

What determines the

economy’s 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
National Income
Income
Outline of model (1 of 2)

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
Factors of production

K = capital:
tools, machines, and structures used in production
L = labor:
the physical and mental efforts of workers
The production function: 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 economy’s level of technology
• Exhibits constant returns to scale
Returns to scale: A review
Initially Y1 = F (K1 , L1 )
Scale all inputs by the same factor z:
K2 = zK1 and L2 = zL1
(example: if z = 1.2, then all inputs are increased by 20%)
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
 Returns to scale: Example 1

F K , L  = KL
F zK , zL  = zK zL 
2
= z KL
2
= z KL
= z KL
= zF K , L 
constant returns to
scale for any z > 0
 Returns to scale: Example 2

F K , L  = K 2 + L2
F zK , zL  = zK   zL 
2 2

= z 2 K 2 + L2 
= z 2F K , L 

increasing
returns to scale
for any z > 1
NOW YOU TRY
Returns to scale
Determine whether each of these production functions has
constant, decreasing, or increasing returns to scale:

K2
(a) F K , L  =
L
(b) F K , L  = K + L
NOW YOU TRY
Answers, part (a)

K2
F (K , L ) =
L
 zK 
2 2 2 2
zK K
F (zK ,zL ) = = =Z
zL zL L
= zF K , L 

constant returns to
scale for any z > 0
NOW YOU TRY
Answers, part (b)

F K , L  = K + L
F zK , zL  = zK + zL
= z K + L 
= zF K + L 

constant returns to
scale for any z > 0
Assumptions

1. Technology is fixed.
2. The economy’s supplies of capital and labor are fixed at:

K = K and L = L
Determining GDP

Output is determined by the fixed factor supplies and the

fixed state of technology:

 
Y = F K,L
The distribution of national income

determined by factor prices, the prices per unit firms pay

for the factors of production
 wage = price of L
 rental rate = price of K
Notation

W = nominal wage
R = nominal rental rate
P = price of output
W /P = real wage
(measured in units of output)
R /P = real rental rate
How factor prices are determined

• Factor prices are determined by supply and demand in

factor markets.
• Recall that the supply of each factor is fixed.
• What about demand?
Demand for labor

• Assume that 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
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)
NOW YOU TRY
Compute and graph MPL
L Y MPL
a. Determine MPL at each 0 0 n.a.
value of L.
1 10 ?
b. Graph the production
2 19 ?
function.
3 27 8
c. Graph the MPL curve with
MPL on the vertical axis 4 34 ?
and L on the horizontal axis. 5 40 ?
6 45 ?
7 49 ?
8 52 ?
9 54 ?
10 55 ?
NOW YOU TRY
Compute and graph MPL, Answers
MPL and the production function
Diminishing marginal returns

• As one input is increased (holding other inputs constant),

its marginal product falls.
• Intuition:
If L increases while holding K fixed, machines per worker
falls, worker productivity falls.
NOW YOU TRY
Identifying diminishing returns
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
NOW YOU TRY
Identifying diminishing returns, answers
Which of these production functions have diminishing
marginal returns to labor?

a) F K , L  = 2K +15L
No, MPL = 15 for all L
b) F K , L  = KL
Yes, MPL falls as L rises
c) F K , L  = 2 K +15 L
Yes, MPL falls as L rises
NOW YOU TRY
MPL and labor demand
L Y MPL
Suppose W/P = 6.
0 0 n.a.
• If L = 3, should the firm hire more
or less labor? Why? 1 10 10
• If L = 7, should the firm hire more 2 19 9
or less labor? Why? 3 27 8
4 34 7
5 40 6
6 45 5
7 49 4
8 52 3
9 54 2
10 55 1
NOW YOU TRY
MPL and labor demand, answers
L Y MPL
Suppose W/P = 6.
0 0 n.a.
• If L = 3, should the firm hire more
or less labor? Why? 1 10 10
Answer: More because the benefit 2 19 9
of the 4th worker (MPL = 7) 3 27 8
exceeds its cost (W/P = 6) 4 34 7
• If L = 7, should the firm hire more 5 40 6
or less labor? Why? 6 45 5
Answer: Less because the 7th 7 49 4
worker adds MPL = 4 units of 8 52 3
output but costs the firm W/P = 6.
9 54 2
10 55 1
MPL and the demand for labor
The equilibrium real wage

The real wage

adjusts to
equate labor
demand with
supply.
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 falls as K rises
The MPK curve is the firm’s demand curve for renting
capital.
Firms maximize profits by choosing K such that MPK =
R/P.
The equilibrium real rental rate

The real rental rate

adjusts to equate
demand for capital
with supply.
The neoclassical theory of distribution

• States that each factor input is paid its marginal product

• A good starting point for thinking about income
distribution
How income is distributed to L and K

W
Total capital income = L = MPL × L
P
R
Total capital income = K = MPK × K
P
If the production function has constant returns to scale,
then
The ratio of labor income to total income in the United
States, 1960–2010
The Cobb-Douglas production function (1 of 2)

• The Cobb–Douglas production function has constant

factor shares:
α = capital’s share of total income:
capital income = MPK × K = αY
labor income = MPL × L = (1 – α )Y
• The Cobb–Douglas production function is:

Y = AK aL1 a

where A represents the level of technology

The Cobb-Douglas production function (2 of 2)

Each factor’s marginal product is proportional to its average

product:

a 1 a aY
MPL = aAK L =
K

MPL = 1 a  AK L a a
=
1 a Y
L
 Labor productivity and wages

Theory: wages depend on labor productivity U.S. data:

Growth Rate of Labor Growth Rate of Real

Time Period
Productivity Wages
1960–2016 2.0% 1.8%
1960–1973 3.0 2.7
1973–1995 1.5 1.2
1995–2010 2.6 2.2
2010–2016 0.5 0.9
Explanations for rising inequality

From The Race Between Education and Technology by

Goldin and Katz:
 Technological progress has increased the demand for
skilled relative to unskilled workers.
 Due to a slowdown in expansion of education, the
supply of skilled workers has not kept up.
 Result: Rising gap between wages of skilled and
unskilled workers.
Outline of model (2 of 2)

A closed economy, market-clearing model

Demand for goods and services

Components of aggregate demand:

C = consumer demand for goods and services
I = demand for investment goods
G = government demand for goods and services
(closed economy: no NX )
Consumption, C

• Disposable income is total income minus total taxes: Y

– T.
• Consumption function: C = C (Y – T )
• Definition: marginal propensity to consume (MPC) is
the change in C when disposable income increases by
one dollar.
The consumption function
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 one’s own funds to
finance investment spending
So, I depends negatively on r
The investment function
Government spending, G

• G = government spending on goods and services

• G excludes transfer payments (for example, Social
Security benefits, unemployment insurance benefits)
• Assume that government spending and total taxes are
exogenous:

G = G and T = T
The market for goods and services

 
Aggregate demand : C Y  T + I r  + G

Aggregate supply : Y = F K , L 

Equilibrium : Y = C Y  T  + I r  + G

The real interest rate adjusts

to equate demand with supply.
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
Demand for funds: Investment

The demand for loanable funds . . .

• comes from investment:
Firms borrow to finance spending on plant and
equipment, new office buildings, etc. Consumers
borrow to buy new houses.
• depends negatively on r:
r is the “price” of loanable funds (cost of borrowing).
Loanable funds demand curve
Supply of funds: Saving

• The supply of loanable funds comes from saving:

• Households use their saving to make bank deposits
and purchase bonds and other assets. These funds
become available to firms to borrow and finance
investment spending.
• The government may also contribute to saving if it
does not spend all the tax revenue it receives.
Types of saving

Private saving = (Y – T) – C
Public saving = T – G
National saving, S
= private saving + public saving
= (Y –T ) – C + T – G
=Y–C–G
 Economic Identity
Y C  I  G  NX
Y  (C  G ) S

S I  NX S  I  NX

Net capital outflow: CF S  I

Current Account: NX
CF  NX
CHAPTER 3 National
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 In a small open economy, interest
rate is determined by the world
interest rate.
The small economy takes r* as given!

Y F ( K , L)
C C (Y  T )
*
I I ( r )

S  I  NX
CHAPTER 3 National
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 S  I  NX
(Y  C  G )  I
*
(Y  C (Y  T )  G )  I (r )
*
S  I ( r )

(if K L are fixed !)

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 *
NX S  I (r ) CF

When r*>r0, capital

will move abroad,
so CF>0!
CF>0 implies NX>0!
That is, capital
outflow leads to
trade surplus!
*
NX CF (r )
CHAPTER 3 National
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 Figure 5-3. A Fiscal Expansion at Home
S Y  C (Y  T )  G
G  ;T  S
Crowd out effect r
*
if r  r
Capital inflow
NX CF until r=r*!
National
NXIncome
CHAPTER 3 National
0
Income
CF  0
 Some Facts

美國利率比中日臺等高 , 因此資金從中日臺流到美國 !
中國是美國的最大貿易逆差國 , 中國也剛好是美國的最大債權國 ! (NX=CF)
日本是美國的第二大貿易逆差國 , 日本也剛好是美國的第二大債權國 ! (NX=CF)
為何中國不將與美貿易賺來的錢 , 借給其他國 ?

CHAPTER 3 National
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 Figure 5-4. A Fiscal Expansion Abroad
*
If foreign is large, G  ; T  * *
r 
*
 r  rr * Capital outflow
until r*=rr*!
CF  NX S  I  0
Trade Surplus.
However, if the
foreign is small, what
CHAPTER 3 National
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Income happen?
 Figure 5-5. A Shift in the Investment Schedule
If having a positive shift in
CF  NX S  I  0 the Investment at home,
I we
 get
r
at home.
But, r* is unchanged since
you are a small country.
Capital inflow to
Home until r=r*!
Trade deficit.
CHAPTER 3 National
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Income
 Production and Interest Rate:
K  (1  )
F ( K , L)  AK L r (1   ) A( )
 1 
L
From the above, a rich country usually has a
higher K/L than a poor country! K K *
( )( * )
L L
Imply: the poor countries have a higher
interest rate than the rich countries, as r  r *

Why, then, capital would not outflow from

the rich countries to the poor countries?
CHAPTER 3 National
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Income
 Why, then, capital would not outflow from the rich
countries to the poor countries?
Technology
Property Rights
Human capital
Information costs
Country risks

CHAPTER 3 National
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Income
 China vs. USA

Before 2003, the USA had been the largest FDI destination
country. That is, many capital flows from the “poor”
countries to the most rich country. Why?
Since 2003, China has exceeded the US and become the
largest FDI destination country in the world. Why?
On one hand, China is the factory of the world; on the other
hand, China is the second largest market in the world.

CHAPTER 3 National
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Income
Notation: Δ = change in a variable

For any variable X, ΔX = “change in X ”

Δ is the Greek (uppercase) letter delta

Examples:
 If ΔL = 1 and ΔK = 0, then ΔY = MPL.
More generally, if ΔK = 0, then ΔY
MPL = .
 Δ(Y − T ) = ΔY − ΔT , so ΔL
ΔC = MPC × (ΔY − ΔT )
= MPC ΔY − MPC ΔT
NOW YOU TRY
Calculate the change in saving
Suppose MPC = 0.8 and MPL = 20.
For each of the following, compute ΔS:
a. ΔG = 100
b. ΔT = 100
c. ΔY = 100
d. ΔL = 10
NOW YOU TRY
Calculate the change in saving, answers

ΔS = ΔY  ΔC  ΔG = ΔY  0.8(ΔY  ΔT )  ΔG
= 0.2 ΔY + 0.8 ΔT  ΔG
a. ΔS =  100
b. ΔS = 0.8 ×100 = 80
c. ΔS = 0.2 ×100 = 20
d. ΔY = MPL × ΔL = 20 ×10 = 200,
ΔS = 0.2 × ΔY = 0.2 × 200 = 40.
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—that is, borrowing.
U.S. federal government surplus/deficit, 1940–2016
U.S. federal government debt, 1940–2016
 Loanable funds supply curve

National saving
S = Y  C(Y  T )  G
does not depend
on r, so the supply
curve is vertical.
Loanable funds market equilibrium

S = Y  C(Y  T )  G
The special role of r

r adjusts to equilibrate the goods market and the loanable

funds market simultaneously:
If the loanable funds market is in equilibrium, then
Y–C–G=I
Add (C +G ) to both sides to get
Y = C + I + G (goods market equilibrium)
Thus,
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.
Mastering the loanable funds model (1 of 2)

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
CASE STUDY: The Reagan Deficits (1 of 2)

• Reagan policies during early 1980s:

• increases in defense spending: ΔG > 0
• big tax cuts: ΔT < 0
• Both policies reduce national saving:
CASE STUDY: The Reagan Deficits (2 of 2)
Are the data consistent with these results?

1970s 1980s
T−G −2.2 −3.9
S 19.6 17.4
r 1.1 6.3
l 19.9 19.4

T – G, S, and I are expressed as a

percentage of GDP.
All figures are averages over the decade
shown.
NOW YOU TRY
The effects of saving incentives
• 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?
Mastering the loanable funds model (2 of 2)

Things that shift the investment curve:

• some technological innovations
• to take advantage of some innovations, firms must
buy new investment goods
• tax laws that affect investment
• example: investment tax credit
An increase in investment demand
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?
 Figure 5-12. Protectionist Trade Policy
If Home raises tariff
against imports, the
NX shifts upward.
But, protection
policy will not
change S and I, so
that NX 0 .

However, Home goods become more expansive

than due to protection! Consumers are worse
CHAPTER 3 National
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off!
 Home raises tariff against imports,
but Foreign still adopt open policy.

Home raises tariff, which makes import more expansive,

reducing the imports.
Home consumers shifts demand toward domestic goods
because them become relatively cheaper than the imported
goods.
NX=export-import increases in the short-run NX  0 !
The increase in demand for the domestic goods push up the
price of domestic goods.
When the price of Home goods increase, the export of Home
goods decrease Home’s real exchange rate increases with
the protection policy.
In the long run, NX 0 !
CHAPTER 3 National
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 The Protectionist Trade Policy

The protection policy first makes import goods more

expensive and then gradually push up the price of domestic
goods.
As a result, consumers suffer lower purchasing power than
before, and become worse!
Protection does not affect trade balance in the long run.
It reduces both import and export, so trade volume
reduces, which also hurts the country.

CHAPTER 3 National
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 蓋特納斥中國低估人幣樹壞榜樣
2010 年 10 月 8 日

中美繼續就人民幣升值問題角力。美國財政部長蓋特納指責，中國維持着一種蓄意低
估，用以扶助出口產業的滙率，並會鼓勵其他國家「有樣學樣」。
IMF 總裁斯特勞斯．卡恩表示，人民幣滙率被低估是全球經濟緊張局勢不斷升級的
原因。若希望避免新的危機出現，中國須加速人民幣升值步伐。
另外，美國亦打「 IMF 牌」，透過威脅不讓中國在 IMF 的投票權增加，來逼中國與美國正式
談判人民幣問題。
溫家寶在布魯塞爾表示，若人民幣滙率不穩定，就會給中國和世界帶來災難。如按一些人的要求把
人民幣滙率升值 20% 至 40% ，中國出口企業將大量倒閉，社會很難穩定。溫家寶呼籲歐盟不
要壓迫中國加快人民幣升值，而中國確實在推進滙率改革。最近歐羅滙率波動很大，但不是人民幣
帶來的，而是美元造成的。中國對美國的貿易順差源自兩國經濟結構差異，與人民幣滙率無關。

CHAPTER 3 National
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 US Dollar vs. Chinese RMB
If China appreciate RMB against by 30%, as
the US wish, will it reduce the trade deficit
of the US?
P
e  e ( * ) 
P

But , S *  I * unchanged !

r * unchanged !

S  I (r * ) unchanged ! NX 0
CHAPTER 3 National
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 美國希望美元對人民幣貶多少？
• 多位經濟學家估算，要使美國的貿易逆差對 GDP 比降低 1% ，美元須貶值約 10% 到 15% ，以利出口。
• 現在美國的 Current Account deficit 赤字約佔其 GDP 的 6% 。
• 要使美國的貿易赤字平衡 (Current Account balance) ，長期而言，美元須貶值約
60%(10%x6) 到 90%(15%x6) 才行。
• 人民幣小幅升值（ 5%~7% ），對改善中、美貿易逆差，減少外匯存底，幫助不大。

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 廣場協議 : Japan vs. USA

1985 年 9 月 22 日，美國財政部長貝克、日本財長竹下登、前聯邦德國財長斯托登伯、法國財長貝格伯、英國
財長勞森等五個發達工業國家財政部長及五國中央銀行行長在美國的紐約廣場飯店（ Plaza Hotel ）達成
五國政府聯合干預外匯市場的協議，使美元對主要貨幣有序地下調，以解決美國巨額的貿易赤字。
廣場協議並非是日本一家被迫與美國簽訂城下之盟，而是諸多國家都與美國簽署了這個協議。
廣場協議前一個交易日，美元兌日元收盤於 240.10 ，而 9 月底則收盤在 216.5 ，到了 1985 年 12
月 31 日，則收盤在 200.25 。到了 1988 年 1 月底，美元兌日元最低到過 120.18 。 1995
年，美元兌日元創造了 79.70 的歷史低點。廣場協議 2 年多後，日元第一輪升值結束，最大升值
99.78% ，而 10 年後，日元已升值了 201.26% 。
「日本第一」口號已成絕響。
取代而之的是「失落的十年」 。

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 圖六、 30 年來，美元對日圓貶了 70%

※ 但日本是儘次於中國，美國貿易第二大逆差國！
CHAPTER 3 National
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 美國對日本貿易赤字走勢

U.S. Trade with Japan: 1985~2004

0
Trade Deficit in $B

-201980 1985 1990 1995 2000 2005

-40
-60
-80
-100
Year

CHAPTER 3 National
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 圖七、 20 年來，美元對臺幣貶了 30%

CHAPTER 3 National
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An increase in investment demand when saving depends
on r
 C H A P T E R S U M M A R Y, PA R T 1
• Total output is determined by:
 the economy’s 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
National Income
Income
 C H A P T E R S U M M A R Y, PA R T 2
• A closed economy’s output is used for consumption,
investment, and government spending.
• The real interest rate adjusts to equate the demand for and
supply of:
 goods and services.
 loanable funds.

CHAPTER 3 National
National Income
Income
 C H A P T E R S U M M A R Y, PA R T 3
• 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
National Income
Income