CHAPTER THREE

macro National Income:

Where it Comes From
and Where it Goes

macroeconomics
fifth edition

N. Gregory Mankiw

PowerPoint Slides
by Ron Cronovich
2003 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
(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
Exercise: determine returns to scale
Determine whether each of the following
production functions has constant, increasing,
or decreasing returns to scale:

K2
(a) F (K ,L) KL (b) F (K ,L)
L
(c) F (K ,L) 2K 15L

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

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

CHAPTER 3 National Income slide 7

 Assumptions of the model
1. Technology is fixed.
2. The economys supplies of capital
and labor are fixed at
K K and LL

CHAPTER 3 National Income slide 8

 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 9

The distribution of national income
determined by factor prices,
the prices per unit that firms pay for
the factors of production.
The wage is the price of L ,
the rental rate is the price of K.

CHAPTER 3 National Income slide 10

 Notation

WW ==nominal
nominalwage
wage
RR ==nominal
nominalrental
rentalrate
rate
PP ==price
priceof
ofoutput
output
W
W/P
/P ==real
realwage
wage
(measured
(measuredin inunits
unitsof
ofoutput)
output)
RR/P
/P ==real
realrental
rentalrate
rate

CHAPTER 3 National Income slide 11

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 12

 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 13

Marginal product of labor (MPL)
def:
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 14

Exercise: compute & graph MPL
a. Determine MPL at L Y MPL
each 0 0 n.a.
value of L 1 10 ?
2 19 ?
b. Graph the production
3 27 8
function
4 34 ?
c. Graph the MPL curve 5 40 ?
with MPL on the 6 45 ?
vertical axis and 7 49 ?
L on the horizontal
8 52 ?
axis
9 54 ?
10 55 ?
CHAPTER 3 National Income slide 15
 answers:

Production function Marginal Product of Labor

12

MPL (units of output)

60
Output (Y)

10
50
8
40
6
30
20 4

10 2

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

CHAPTER 3 National Income slide 16

 The MPL and the production
function
Y
output
F (K , L)
MP
1 L As more labor
MP is added, MPL

1 L

Slope of the
MP
L production function
equals MPL
1
L
labo
CHAPTER 3 National Income r
slide 17
 Diminishing marginal returns
As a factor input is increased, its
marginal product falls (other things
equal).
Intuition:
L while holding K fixed
fewer machines per worker
lower productivity

CHAPTER 3 National Income slide 18

 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 19

Exercise (part 2)
L Y MPL
Suppose W/P = 6. 0 0 n.a.
1 10 10
d. If L = 3, should firm hire
2 19 9
more or less labor? Why?
3 27 8
e. If L = 7, should firm hire 4 34 7
more or less labor? Why? 5 40 6
6 45 5
7 49 4
8 52 3
9 54 2
10 55 1

CHAPTER 3 National Income slide 20

MPL and the demand for labor
Units of
output Each
Each firm
firm hires
hires
labor
labor
up
up to
to the
the point
point
Real where
where MPL
MPL = = W/P
W/P
wag
e

MPL,
Labor
demand
Units of labor,
Quantity of L
labor
demanded
CHAPTER 3 National Income slide 21
 The equilibrium real wage
Units of Labor
output supply

equilibriu
m real MPL,
wage Labor
demand
L Units of labor,
L
The
The real
real wage
wage adjusts
adjusts to
to
equate
equate
CHAPTER labor
3labor demand
National with
with supply.
Income
demand supply. slide 22
 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 23

 The equilibrium real rental rate
Units of
output Supply of The
The real
real rental
rental
capital rate
rate adjusts
adjusts toto
equate
equate
demand
demand for for
capital
capital with
with
supply.
supply.
equilibriu
m R/P MPK,
demand for
capital
K Units of capital,
K

CHAPTER 3 National Income slide 24

 The
The Neoclassical
Neoclassical Theory
Theory
of
of Distribution
Distribution

states
states that
that each
each factor
factor input
input isis
paid
paid its
its marginal
marginal product
product
accepted
accepted by
by most
most economists
economists

CHAPTER 3 National Income slide 25

 How income is distributed:
W
total labor income = L MPL L
P
R
total capital income K MPK K
P
=
If production function has constant
returns to scale, then
Y MPL L MPK K

national labor capital

income income income

CHAPTER 3 National Income slide 26

 Outline of model
A closed economy, market-clearing model
Supply side
DONE
factor markets (supply, demand,
DONE price)
determination of output/income

Demand side
Next
determinants of C, I, and G

Equilibrium
goods market
loanable funds market

CHAPTER 3 National Income slide 27

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 28

 Consumption, C
def: disposable income is total
income minus total taxes: YT
Consumption function: C = C (Y T )
Shows that (Y T ) C
def: The marginal propensity to
consume is the increase in C caused
by a one-unit increase in disposable
income.

CHAPTER 3 National Income slide 29

 The consumption function
C

C (Y
T)

The slope of the

MPC
consumption
1 function is the
MPC.

YT

CHAPTER 3 National Income slide 30

 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 31

 The investment function
r
Spending on
investment goods
is a downward-
sloping function of
the real interest
rate

I
(r )
I

CHAPTER 3 National Income slide 32

 Government spending, G
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

CHAPTER 3 National Income slide 33

The market for goods & services

Agg. demand: C (Y T ) I (r ) G

Agg. supply: Y F (K , L)

Equilibrium: Y = C (Y T ) I (r ) G

The
The real
real interest
interest rate
rate adjusts
adjusts
to
to equate
equate demand
demand with
with supply.
supply.

CHAPTER 3 National Income slide 34

 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 35

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 (the cost of
borrowing).

CHAPTER 3 National Income slide 36

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

I
(r )
I

CHAPTER 3 National Income slide 37

 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 of the tax
revenue it receives.

CHAPTER 3 National Income slide 38

 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 39

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
MPL
More generally, if K = 0, then .
L
(YT ) = Y T , so
C = MPC (Y T )
= MPC Y MPC T
CHAPTER 3 National Income slide 40
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 41

 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 42

 digression:
Budget surpluses and deficits
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.

CHAPTER 3 National Income slide 43

 The U.S. Federal Government Budget
5%

0%
percent of GDP

-5%

-10% (T-G)
(T-G)as
asaapercent
percentof
ofGDP
GDP

-15%
1940 1950 1960 1970 1980 1990 2000

CHAPTER 3 National Income slide 44

 The U.S. Federal Government Debt
Fact:
Fact: In
Inthe
theearly
early1990s,
1990s,
about
about1818cents
centsof ofevery
everytax
tax
120%
dollar
dollarwent
wentto topay
payinterest
intereston
on
the
thedebt.
debt.
100% (Today
(Todayits
itsabout
about99cents.)
cents.)
percent of GDP

80%

60%

40%

20%
1940 1950 1960 1970 1980 1990 2000

CHAPTER 3 National Income slide 45

 Loanable funds supply curve
r S Y C (Y T ) G

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

S, I

CHAPTER 3 National Income slide 46

Loanable funds market equilibrium
r S Y C (Y T ) G

Equilibrium real
interest rate

I (r )
Equilibrium level S, I
of investment

CHAPTER 3 National Income slide 47

 The special role of r
rr adjusts
adjusts toto 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
Y
Y==CC+ + II +
+GG (goods
(goods market
market eqm)
eqm)
Thus,
Eqm in
Thus, L.F. Eqm in
goods
market market
CHAPTER 3 National Income slide 48
Digression: mastering models
To learn a model well, 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 49

Mastering the loanable funds model
1. 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 50

CASE STUDY
The Reagan Deficits
Reagan policies during early 1980s:
increases in defense
spending: G > 0
big tax cuts: T < 0

According to our model, both policies

reduce national saving:
S Y C (Y T ) G

G S T C S

CHAPTER 3 National Income slide 51

 1. The Reagan deficits, cont.

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.

CHAPTER 3 National Income slide 52

Are the data consistent with these results?

variable
variable 1970s
1970s 1980s
1980s
TT G
G 2.2
2.2 3.9
3.9
SS 19.6
19.6 17.4
17.4
rr 1.1
1.1 6.3
6.3
II 19.9
19.9 19.4
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 53

 Now you try
Draw the diagram for the loanable
funds model.
Suppose the tax laws are altered to
provide more incentives for private
saving.
What happens to the interest rate and
investment?
(Assume that T doesnt change)

CHAPTER 3 National Income slide 54

Mastering the loanable funds model
2. Things that shift the investment curve
certain 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 55

An increase in investment demand
r S
An increase
raises the in desired
interest rate. r2 investment

r1

But the equilibrium

level of investment I2
cannot increase I1
because the
S, I
supply of loanable
funds is fixed.
CHAPTER 3 National Income slide 56
 Chapter summary
1. Total output is determined by
how much capital and labor the economy
has
the level of technology

2. Competitive firms hire each factor until its

marginal product equals its price.

3. If the production function has constant

returns to scale, then labor income plus
capital income equals total income (output).

CHAPTER 3 National Income slide 59

 Chapter summary
4. The economys output is used for
consumption
(which depends on disposable income)
investment
(depends on the real interest rate)
government spending
(exogenous)
5. The real interest rate adjusts to equate
the demand for and supply of
goods and services
loanable funds

CHAPTER 3 National Income slide 60

 Chapter summary
6. A decrease in national saving causes the
interest rate to rise and investment to fall.

7. 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 61

CHAPTER 3 National Income slide 62