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 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 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

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 Factors of production
K = capital,
tools, machines, and structures
used in production

L = labor,
the physical and mental efforts of
workers

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 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 economy’s level of technology.
 exhibits constant returns to scale.

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 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
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Exercise: determine returns to scale
Determine whether each of the following
production functions has constant, increasing,
or decreasing returns to scale:
2
K
(a) F (K , L )  K L (b) F (K , L ) 
L

( c) F (K , L )  2K  1 5L

(d) F (K , L )  2 K  15 L

(e) F (K , L )  2K
2
 15 L2

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

K K and L L

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 Determining GDP
Output is determined by the fixed factor
supplies and the fixed state
of technology:

Y F (K , L )

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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.

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 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

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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?

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 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

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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)

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

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The MPL and the production function
Y
output
F (K , L )

MPL
1 As more labor is
MPL added, MPL 
1

MPL Slope of the production

function equals MPL
1
L
labor
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 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

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 Check your understanding:
Which of these production functions have
diminishing marginal returns to labor?

a) F (K , L )  2K  1 5L

b) F (K , L )  K L

c) F (K , L )  2 K  15 L

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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

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

MPL, Labor
demand

Units of labor, L
Quantity of labor
demanded

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 The equilibrium real wage
Units of Labor
output supply

equilibrium
real wage MPL, Labor
demand

L Units of labor, L

The real wage adjusts to equate

labor demand with supply.
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 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 firm’s demand curve
for renting capital.
 Firms maximize profits by choosing K
such that MPK = R/P .

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 The equilibrium real rental rate
Units of
output Supply of The real rental rate
capital
adjusts to equate
demand for capital
with supply.

equilibrium
R/P MPK, demand
for capital

K Units of capital, K

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 The Neoclassical Theory
of Distribution

 states that each factor input is

paid its marginal product
 accepted by most economists

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 How income is distributed:
W
total labor income = L  M PL L
P

R
total capital income = K  M PK 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, price)
DONE  determination of output/income

Demand side
Next   determinants of C, I, and G
Equilibrium
 goods market
 loanable funds market

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 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 )

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 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: The marginal propensity to consume is
the increase in C caused by a one-unit
increase in disposable income.

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 The consumption function
C

C (Y –T )

The slope of the

MPC
consumption
1 function is the MPC.

Y–T

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 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, r  I

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

I (r )

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 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

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The market for goods & services

 Agg. dem an d: C (Y T ) I (r ) G

 A g g . su p p ly : Y F (K , L )

 E q u ilib r iu m : Y = C (Y T ) I (r ) G

The real interest rate adjusts

to equate demand with supply.

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 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).

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

I (r )

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 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 + T – G
= 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
More generally, if K = 0, then MPL  .
L
 (YT ) = Y  T , so
C = MPC  (Y  T )
= MPC Y  MPC T
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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   1 0 0

b. S  0.8 100  80

c. S  0.2 100  20

d. Y  M PL  L  20 10  200,

S  0.2  Y  0.2  200  40.

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 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.

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The U.S. Federal Government Budget

(T-G) as a percent of GDP

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The U.S. Federal Government Debt
Fact: In the early 1990s,
about 18 cents of every tax
dollar went to pay interest
on the debt.
(Today it’s about 9 cents.)

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 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

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

Equilibrium real
interest rate

I (r )
Equilibrium level S, I
of investment

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 The special role of r
r adjusts to equilibrate the goods market and the
loanable funds market simultaneously:
If L.F. market in equilibrium, then
Y–C–G =I
Add (C +G ) to both sides to get
Y = C + I + G (goods market eq’m)
Thus,
Eq’m in L.F.
market  Eq’m in goods
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

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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

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 1. The Reagan deficits, cont.

1.The increase in the r

S S 1
deficit reduces 2

saving…

r2
2.…which causes the
real interest rate to
r1
rise…

3.…which reduces I (r )
the level of I2 I1 S, I
investment.

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Are the data consistent with these results?

variable 1970s 1980s

T – G –2.2 –3.9
S 19.6 17.4
r 1.1 6.3
I 19.9 19.4

T–G, 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 doesn’t 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

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 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
supply of loanable S, I
funds is fixed.

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 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?

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 An increase in investment demand when
saving depends on the interest rate
Real interest rate, r
S( r )

1. An increase
in desired
2. . . . raises B
investment . ..
the interest
rate . . A I2

3. . . . and raises I1
equilibrium investment
and saving.

Investment, Saving, I, S

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 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 economy’s 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