Chapter 3

National Income
Modified by Yun Wang
Eco 3203 Intermediate Macroeconomics
Florida International University
Summer 2017
© 2016 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

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

3
Factors of production
K = capital:
tools, machines, and structures used in
production
L = labor:
the physical and mental efforts of workers

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 economy’s level of technology
• exhibits constant returns to scale

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

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Example 1
F (K , L)  KL
F (zK , zL)  (zK )(zL)

 z 2KL

 z 2 KL

 z KL
constant returns to
 z F (K , L)
scale for any z > 0
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Example 2
F (K , L)  K L
F (zK , zL)  zK  zL

 z K z L

 z  K L 
decreasing
 z F (K , L) returns to scale
for any z > 1

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Example 3
F (K , L)  K 2  L2

F (zK , zL)  (zK )2  (zL)2

 z 2  K 2  L2 
increasing returns
 z F (K , L)
2
to scale for any
z>1

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Now you try…
• Determine whether constant, decreasing, or
increasing returns to scale for each of these
production functions:
2
(a) F (K , L)  K
L
(b) F (K , L)  K  L

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Answer to part (a)
2
K
F (K , L) 
L
(zK )2
F (zK , zL) 
zL
z 2K 2

zL
K2
 z
L
constant returns to
 z F (K , L) scale for any z > 0
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Answer to part (b)
F (K , L)  K  L

F (zK , zL)  zK  zL

 z (K  L)

constant returns to
 z F (K , L)
scale for any z > 0

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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
• wage = price of L
• rental rate = 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?

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

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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)

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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
4 34 ?
c. Graph the MPL curve with 5 40 ?
MPL on the vertical axis and 6 45 ?
L on the horizontal axis. 7 49 ?
8 52 ?
9 54 ?
10 55 ?

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 Answers:
Production function Marginal Product of Labor
12

MPL (units of output)

Output (Y)

60
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)

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

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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

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 Exercise (part 2) L Y MPL
0 0 n.a.
1 10 10
Suppose W/P = 6. 2 19 9
d. If L = 3, should firm hire more or 3 27 8
less labor? Why? 4 34 7
e. If L = 7, should firm hire more or 5 40 6
less labor? Why? 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 The real wage
supply
adjusts to equate
labor demand
with supply.

equilibrium
real wage MPL,
Labor
demand
L Units of labor, L

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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
• is accepted by most economists

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 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

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 The ratio of labor income to total income in the U.S.

Labor’s
share
of total
income

Labor’s share of income

is approximately constant over time.
(Hence, capital’s share is, too.)

32
The Cobb-Douglas Production
Function
• The Cobb-Douglas production function has constant
factor shares:
 = capital’s 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.

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The Cobb-Douglas Production
Function
• Each factor’s marginal product is proportional to its
average product:
Y
MPK   AK L   1 1

K
  (1   )Y
MPL  (1   ) AK L 
L

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 Outline of model
A closed economy, market-clearing model
Supply side
DONE q factor markets (supply, demand, price)

DONE q determination of output/income

Demand side
Next  q determinants of C, I, and G
Equilibrium
q goods market
q 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 )

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.

37
The consumption function
C

C (Y –T )

The slope of the

MPC
consumption function
1 is the MPC.

Y–T

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 one’s own funds to
finance investment spending.
So, r  I

39
 The investment function
r
Spending on
investment goods
depends negatively on
the real interest rate.

I (r )

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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 and T T

41
The market for goods & 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.

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

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).

44
Loanable funds demand curve
r
The investment
curve is also the
demand curve for
loanable funds.

I (r )

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.

46
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

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
§ (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

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.
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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.

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U.S. Federal Government Surplus/Deficit, 1940-2004

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U.S. Federal Government Debt,
1940-2004

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

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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.

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

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 T   C   S

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CASE STUDY:
The Reagan deficits
1. The increase in r S1
S 2
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.

60
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.

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?

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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

63
An increase in investment demand
r S

…raises the An increase

interest rate. r2 in desired
investment…
r1
But the equilibrium
level of investment I2
cannot increase I1
because the
S, I
supply of loanable
funds is fixed.
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?

65
 An increase in investment demand when saving
depends on r
r S (r )
An increase in
investment demand
raises r,
which induces an r2
increase in the
r1
quantity of saving,
which allows I
to increase. I(r)2
I(r)
I1 I2 S, I

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• 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).

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• A closed economy’s 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

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• 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.

69