Macroeconomics I

E_EBE1_MACEC

Dennis Bonam
[email protected], [email protected]
De Nederlandsche Bank
February-March, 2021
A simple macro model

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 A simple macro 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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 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

• Assumes 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
(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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 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

• National income is determined by factor prices, i.e.

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?

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

Slope of the production

MPL
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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 The equilibrium real wage rate

Units of
output Supply of The real wage rate
labor adjusts to equate
demand for labor
with supply

equilibrium
W/P MPL, demand
for labor

𝐿 Units of labor, L

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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…

– as a first approximation
– with deviations requiring some study

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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 Cobb-Douglas production function
• The Cobb-Douglas production function is:
 1−
Y = AK L
where A represents the level of technology

• 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

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 Labor income share, current national prices
(1980-2017)
0,75

0,7

0,65 NL
0,6 JA
US
0,55

0,5
1980 1985 1990 1995 2000 2005 2010 2015

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 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 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 )

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 Consumption, C

• Disposable income is total income minus total taxes:

Y–T
• Consumption function: C = C(Y – T )
Assumes that (Y – T )  C
• Marginal propensity to consume (MPC) 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 function
1 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, i.e. 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 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
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 Outline of model
A closed economy, market-clearing model
Supply side
DONE ✓❑ factor markets (supply, demand, price)

DONE ✓❑ determination of output/income

Demand side
DONE ✓
❑ determinants of C, I, and G

Equilibrium
❑ goods market
❑ loanable funds market

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 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 and 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

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 Demand for funds: investment
The demand for loanable funds…
– comes from investment:
Firms borrow to finance their spending on plant and
equipment, new office buildings, etc. Consumers borrow to
buy new houses.
– depends negatively on r,
the “price” of loanable funds (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 savings 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

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 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
=> S = I(r)

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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 loanable funds 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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 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
– Pension contributions
– Life-cycle savings accounts
– consumption tax vs income tax

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 Mastering the loanable funds model
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

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 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
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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 r
r
An increase in S (r )
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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