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# National Income: Where it Comes From and Where it Goes - PowerPoint PPT Presentation

3. National Income: Where it Comes From and Where it Goes. 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

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### National Income:Where it Comes From and Where it Goes

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

K = capital: tools, machines, and structures used in production

L = labor: the physical and mental efforts of workers

CHAPTER 3 National Income

• denoted Y = F(K,L)

• shows how much output (Y) the economy can produce fromKunits of capital and Lunits of labor

• reflects the economy’s level of technology

• exhibits constant returns to scale

CHAPTER 3 National Income

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

• Determine whether constant, decreasing, or increasing returns to scale for each of these production functions:

(a)

(b)

CHAPTER 3 National Income

• Technology is fixed.

• The economy’s supplies of capital and labor are fixed at

CHAPTER 3 National Income

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

CHAPTER 3 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

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

CHAPTER 3 National Income

• Factor prices are determined by supply and demand in factor markets.

• Recall: Supply of each factor is fixed.

CHAPTER 3 National Income

• 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

• 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

CHAPTER 3 National Income

1

As more labor is added, MPL 

MPL

1

Slope of the production function equals MPL

1

MPL and the production function

Y

output

MPL

L

labor

CHAPTER 3 National Income

• 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

Real wage

MPL, Labor demand

Units of labor, L

Quantity of labor demanded

MPL and the demand for labor

Each firm hires labor up to the point where MPL = W/P.

CHAPTER 3 National Income

Labor supply

Units of output

equilibrium real wage

MPL, Labor demand

Units of labor, L

The equilibrium real wage

The real wage adjusts to equate labor demand with supply.

CHAPTER 3 National Income

We have just seen that MPL= W/P.

The same logic shows that MPK= R/P:

• diminishing returns to capital: MPK as K

• The MPKcurve is the firm’s demand curve for renting capital.

• Firms maximize profits by choosing Ksuch that MPK = R/P.

CHAPTER 3 National Income

Supply of capital

equilibrium R/P

MPK, demand for capital

Units of capital, K

The equilibrium real rental rate

The real rental rate adjusts to equate demand for capital with supply.

CHAPTER 3 National Income

The Neoclassical Theory of Distribution

• states that each factor input is paid its marginal product

• is accepted by most economists

CHAPTER 3 National Income

nationalincome

capitalincome

laborincome

How income is distributed:

total labor income =

total capital income =

If production function has constant returns to scale, then

CHAPTER 3 National Income

Labor’s share of total income

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

CHAPTER 3 National Income

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

DONE

DONE 

Next

CHAPTER 3 National Income

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

• 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

C(Y –T )

The slope of the consumption function is the MPC.

MPC

1

Y – T

The consumption function

CHAPTER 3 National Income

• 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

CHAPTER 3 National Income

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

I(r)

I

The investment function

CHAPTER 3 National Income

• 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:

CHAPTER 3 National Income

• Aggregate demand:

• Aggregate supply:

• Equilibrium:

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

CHAPTER 3 National Income

• 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

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

I(r)

I

Loanable funds demand curve

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

CHAPTER 3 National Income

• 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

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

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

CHAPTER 3 National Income

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

CHAPTER 3 National Income

CHAPTER 3 National Income

U.S. Federal Government Debt, 1940-2005

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.)

CHAPTER 3 National Income

S, I

Loanable funds supply curve

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

CHAPTER 3 National Income

Equilibrium real interest rate

I(r)

Equilibrium level of investment

S, I

Loanable funds market equilibrium

CHAPTER 3 National Income

Eq’m in goods market

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,

CHAPTER 3 National Income

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

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

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:

CHAPTER 3 National Income

r2

r1

I(r)

S, I

CASE STUDY: The Reagan deficits

1. The increase in the deficit reduces saving…

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

3. …which reduces the level of investment.

I2

I1

CHAPTER 3 National Income

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

…raises the interest rate.

r2

But the equilibrium level of investment cannot increase because thesupply of loanable funds is fixed.

I2

I1

S, I

An increase in investment demand

An increase in desired investment…

r1

CHAPTER 3 National Income

• 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

r2

I(r)2

I(r)

S, I

I2

An increase in investment demand when saving depends on r

An increase in investment demand raises r,

which induces an increase in the quantity of saving,

which allows Ito increase.

r1

I1

CHAPTER 3 National Income

• 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 Income

slide 53

• 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

CHAPTER 3 National Income

slide 54

• 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 55

The classical theory of inflation

causes

effects

social costs

“Classical” – assumes prices are flexible & markets clear

Applies to the long run

CHAPTER 4 Money and Inflation

U.S. inflation and its trend, 1960-2007

% change in CPI from 12 months earlier

15%

12%

long-run trend

9%

6%

3%

0%

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

slide 57

The connection between money and prices

Inflation rate = the percentage increase in the average level of prices.

Price = amount of money required to buy a good.

Because prices are defined in terms of money, we need to consider the nature of money, the supply of money, and how it is controlled.

CHAPTER 4 Money and Inflation

Money is the stock of assets that can be readily used to make transactions.

CHAPTER 4 Money and Inflation

medium of exchangewe use it to buy stuff

store of valuetransfers purchasing power from the present to the future

unit of accountthe common unit by which everyone measures prices and values

CHAPTER 4 Money and Inflation

1.fiat money

has no intrinsic value

example: the paper currency we use

2.commodity money

has intrinsic value

examples: gold coins, cigarettes in P.O.W. camps

CHAPTER 4 Money and Inflation

The money supply and monetary policy definitions

The money supply is the quantity of money available in the economy.

Monetary policy is the control over the money supply.

CHAPTER 4 Money and Inflation

Monetary policy is conducted by a country’s central bank.

In the U.S., the central bank is called the Federal Reserve(“the Fed”).

The Federal Reserve Building Washington, DC

CHAPTER 4 Money and Inflation

Money supply measures, May 2007

C

Currency

\$755

M1

C + demand deposits, travelers’ checks, other checkable deposits

\$1377

M2

M1 + small time deposits, savings deposits, money market mutual funds, money market deposit accounts

\$7227

symbol

assets included

amount (\$ billions)

CHAPTER 4 Money and Inflation

A simple theory linking the inflation rate to the growth rate of the money supply.

Begins with the concept of velocity…

CHAPTER 4 Money and Inflation

basic concept: the rate at which money circulates

definition: the number of times the average dollar bill changes hands in a given time period

example: In 2007,

\$500 billion in transactions

money supply = \$100 billion

The average dollar is used in five transactions in 2007

So, velocity = 5

CHAPTER 4 Money and Inflation

Velocity, cont.

This suggests the following definition:

where

V = velocity

T = value of all transactions

M = money supply

CHAPTER 4 Money and Inflation

Velocity, cont.

Use nominal GDP as a proxy for total transactions.

Then,

where

P = price of output (GDP deflator)

Y = quantity of output (real GDP)

P Y = value of output (nominal GDP)

CHAPTER 4 Money and Inflation

The quantity equationM V = P Yfollows from the preceding definition of velocity.

It is an identity:it holds by definition of the variables.

CHAPTER 4 Money and Inflation

M/P = real money balances, the purchasing power of the money supply.

A simple money demand function: (M/P)d = kYwherek = how much money people wish to hold for each dollar of income. (kis exogenous)

CHAPTER 4 Money and Inflation

money demand: (M/P)d = kY

quantity equation: M V = P Y

The connection between them: k = 1/V

When people hold lots of money relative to their incomes (kis high), money changes hands infrequently (Vis low).

CHAPTER 4 Money and Inflation

starts with quantity equation

assumes V is constant & exogenous:

With this assumption, the quantity equation can be written as

CHAPTER 4 Money and Inflation

The quantity theory of money, cont.

How the price level is determined:

With V constant, the money supply determines nominal GDP (P Y ).

Real GDP is determined by the economy’s supplies of K and L and the production function (Chap 3).

The price level is P = (nominal GDP)/(real GDP).

CHAPTER 4 Money and Inflation

The quantity theory of money, cont.

Recall from Chapter 2: The growth rate of a product equals the sum of the growth rates.

The quantity equation in growth rates:

CHAPTER 4 Money and Inflation

The quantity theory of money, cont.

 (Greek letter “pi”) denotes the inflation rate:

The result from the preceding slide was:

Solve this result for  to get

CHAPTER 4 Money and Inflation

The quantity theory of money, cont.

Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions.

Money growth in excess of this amount leads to inflation.

CHAPTER 4 Money and Inflation

The quantity theory of money, cont.

Y/Y depends on growth in the factors of production and on technological progress (all of which we take as given, for now).

Hence, the Quantity Theory predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate.

CHAPTER 4 Money and Inflation

The quantity theory of money implies

1. countries with higher money growth rates should have higher inflation rates.

2. the long-run trend behavior of a country’s inflation should be similar to the long-run trend in the country’s money growth rate.

Are the data consistent with these implications?

CHAPTER 4 Money and Inflation

U.S. inflation and money growth, 1960-2007

15%

M2 growth rate

12%

9%

6%

3%

inflation rate

0%

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

Over the long run, the inflation and money growth rates move together, as the quantity theory predicts.

slide 79

To spend more without raising taxes or selling bonds, the govt can print money.

The “revenue” raised from printing money is called seigniorage (pronounced SEEN-your-idge).

The inflation tax:Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money.

CHAPTER 4 Money and Inflation

Nominal interest rate, inot adjusted for inflation

Real interest rate, radjusted for inflation:r = i 

CHAPTER 4 Money and Inflation

The Fisher equation:i = r + 

Chap 3: S = I determines r.

Hence, an increase in causes an equal increase in i.

This one-for-one relationship is called the Fisher effect.

CHAPTER 4 Money and Inflation

nominal interest rate

inflation rate

percent per year

15%

12%

9%

6%

3%

0%

-3%

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

slide 83