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makro ch3

macroeconomics ch3

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makro ch3

macroeconomics ch3

Uploaded by

kamiltsugamibusiness
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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National Income: Where It Comes From and Where It Goes

Model Overview
This chapter explores how national income is determined in a closed
economy, where there is no interaction with the rest of the world. It
focuses on three aspects:

1. Supply Side: The economy’s output (national income) is


determined by the availability of production inputs—capital (K), labor
(L)—and the state of technology.

2. Demand Side: National income is used for consumption (C),


investment (I), and government spending (G). These together form
aggregate demand.

3. Equilibrium: The real interest rate (r) adjusts to ensure that


aggregate demand matches aggregate supply.

This framework provides insights into how income is generated,


distributed, and spent in an economy.

Factors of Production

 Capital (K): Includes physical assets like machinery, tools, and


buildings that are used in production.

 Labor (L): Represents the efforts—both physical and mental—of


workers in production activities.

Both factors are essential for producing goods and services. Together, they
determine the economy’s total output, also referred to as gross domestic
product (GDP).

Historical Example: During the Industrial Revolution, new machines


(capital) like the spinning jenny and steam engine complemented workers
(labor), significantly increasing productivity and output.

Production Function

The production function describes the relationship between the quantity of


inputs used and the quantity of output produced. It assumes:

1. Constant Returns to Scale: If inputs (K and L) are doubled, output


(Y) also doubles.

2. Fixed Technology: The state of technology is assumed to be


constant in the short run.
Example: A factory doubles its workforce and machinery. As a result, its
output also doubles. This demonstrates constant returns to scale.

National Income Distribution

National income is distributed based on the productivity of the factors of


production:

 Labor Income: Wages paid to workers, determined by the marginal


productivity of labor (MPL).

 Capital Income: Payments to owners of capital, determined by the


marginal productivity of capital (MPK).

Competitive markets ensure that each factor of production is paid


according to its contribution to total output.

Concept of Diminishing Returns: When one factor (e.g., labor) is


increased while the other (e.g., capital) remains fixed, the additional
output generated (marginal product) eventually decreases.

Example: A farmer with a fixed plot of land hires more workers. Initially,
output increases significantly. However, as the land becomes overcrowded,
the contribution of additional workers diminishes.

Historical Context: During the 19th century, as U.S. farmland expanded


westward, productivity per worker increased. However, as land availability
declined in some regions, marginal returns to labor decreased.

Labor and Capital Productivity

 Firms hire labor until the benefit of an additional worker (MPL) equals
the cost of hiring that worker (the real wage, W/P).

 Similarly, firms rent capital until the benefit of an additional unit of


capital (MPK) equals its cost (the real rental rate, R/P).

This ensures efficient allocation of resources in production.

Example: In a manufacturing plant, additional workers are hired until their


marginal contribution no longer justifies the wage cost.

Historical Example: Post-World War II, U.S. industries invested heavily in


capital (e.g., machinery) to boost productivity. This led to rising wages as
labor productivity improved.
Cobb-Douglas Production Function

The Cobb-Douglas production function assumes:

1. Labor and capital each receive a constant share of total income.

2. The marginal products of labor and capital are proportional to their


contributions to output.

Historical Example: From the 1950s to the 1970s, U.S. national income
distribution between labor and capital remained stable, reflecting the
Cobb-Douglas framework.

Aggregate Demand

Aggregate demand reflects how national income is spent and consists of


three components:

1. Consumption (C): Spending by households on goods and services.


It depends on disposable income (Y - T), where T represents taxes.
Example: In the 1950s, rising disposable incomes led to increased
household spending on cars, televisions, and other durable goods.

2. Investment (I): Spending on goods that will produce future output,


such as buildings, machinery, and infrastructure. Investment
depends negatively on the real interest rate (r).
Example: During the 1990s, low interest rates fueled a surge in IT
infrastructure investment during the dot-com boom.

3. Government Spending (G): Expenditures by the government on


goods and services, excluding transfer payments like unemployment
benefits or social security.

Historical Context: The New Deal programs in the 1930s significantly


increased G, stimulating demand and aiding recovery from the Great
Depression.

Loanable Funds Market

The loanable funds market connects savers (supply of funds) with


borrowers (demand for funds):

 Supply of Funds: Comes from national saving, which includes


private saving (household savings) and public saving (government
budget surpluses).
 Demand for Funds: Comes from investment needs by businesses
and individuals.

Real Interest Rate (r): The price of borrowing funds, which adjusts to
equilibrate the market.

Historical Example: During the Reagan administration in the 1980s, a


combination of tax cuts and increased defense spending reduced national
saving. This led to higher real interest rates, discouraging private
investment—a phenomenon known as "crowding out."

Historical Case: The Reagan Deficits

The Reagan administration’s fiscal policies included:

 Tax Cuts: Reduced government revenue (T), leading to lower public


saving.

 Increased Defense Spending: Higher government spending (G)


further reduced national saving.

Impact:

 National saving decreased, shifting the supply of loanable funds


leftward.

 Real interest rates rose from an average of 1.1% in the 1970s to


6.3% in the 1980s.

 Higher borrowing costs discouraged private investment, particularly


in capital-intensive industries.
Investor Tips

1. Monitor Productivity Trends: High productivity growth often


signals opportunities in innovative sectors. For example, tech stocks
surged in the 1990s due to advances in IT.

2. Watch Fiscal Policy: Expansionary fiscal policies, like infrastructure


investments, often benefit sectors such as construction and
materials.

3. Focus on Interest Rates: Rising rates can hurt borrowing-


dependent industries (e.g., real estate) but may favor defensive
stocks (e.g., utilities).
4. Analyze National Saving: Declines in saving often lead to higher
interest rates, reducing growth prospects for capital-intensive
industries.

5. Evaluate Crowding-Out Effects: Large fiscal deficits, like those


during the Reagan era, can suppress private investment
opportunities.

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