Chapter 3:

National Income:
Where it Comes From
and Where it Goes

CHAPTER 3 National Income

 Introduction

 In the last lecture we defined and

measured some key macroeconomic
variables.
 Now we start building theories about what
determines these key variables.
 In the next couple lectures we will build up
theories that we think hold in the long run,
when prices are flexible and markets clear.

 Called Classical theory or Neoclassical.

CHAPTER 3 National Income slide 2

 The Neoclassical model

Is a general equilibrium model:

 Involves multiple markets
 each with own supply and demand
 Price in each market adjusts to make
quantity demanded equal quantity supplied.

CHAPTER 3 National Income slide 3

 Neoclassical model
The macroeconomy involves three types of
markets:
1. Goods (and services) Market
2. Factors Market or Labor market , needed to
produce goods and services
3. Financial market

Are also three types of agents in an economy:

1. Households
2. Firms
3. Government
CHAPTER 3 National Income slide 4
Three Markets – Three agents

work
Labor Market hiring

Financial Market
saving borrowing borrowing

Households Government Firms

government production
spending
consumption investment

Goods Market

CHAPTER 3 National Income slide 5

 Neoclassical model

Agents interact in markets, where they may

be demander in one market and supplier in
another

1) Goods market:
Supply: firms produce the goods
Demand: by households for consumption,
government spending, and other firms
demand them for investment

CHAPTER 3 National Income slide 6

 Neoclassical model
2) Labor market (factors of production)
Supply: Households sell their labor services.
Demand: Firms need to hire labor to
produce the goods.

3) Financial market
Supply: households supply private savings:
income less consumption
Demand: firms borrow funds for
investment; government borrows funds to
finance expenditures.

CHAPTER 3 National Income slide 7

 Neoclassical model
 We will develop a set of equations to
charac-terize supply and demand in these
markets

 Then use algebra to solve these equations

together, and see how they interact to
establish a general equilibrium.

 Start with production…

CHAPTER 3 National Income slide 8

Part 1: Supply in goods market:
Production
Supply in the goods market depends
on a production function:
denoted Y = F (K, L)

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

L = labor: the physical and mental

efforts of workers

CHAPTER 3 National Income slide 9

 The production function
 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.
 Generally, we will assume it exhibits
constant returns to scale.

CHAPTER 3 National Income slide 10

 Returns to scale
Initially Y1 = F (K1 , L1 )
Scale all inputs by the same multiple z:
K2 = zK1 and L2 = zL1 for z>1
(If z = 1.25, then all inputs increase 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 slide 11
Exercise: determine returns to scale
Determine whether the following production
function has constant, increasing, or
decreasing returns to scale:

F (K ,L)  2K  15L

CHAPTER 3 National Income slide 12

Exercise: determine returns to scale
Does F (zK , zL)  zF (K ,L)?

Suppose F (K ,L)  2K  15L

F (zK , zL)  2zK   15zL 
 z (2K  15L)
 zF (K ,L)

Yes, constant returns to scale

CHAPTER 3 National Income slide 13

 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

CHAPTER 3 National Income slide 14

 Determining GDP

Output is determined by the fixed

factor supplies and the fixed state
of technology:

So we have a simple initial theory

of supply in the goods market:

Y F (K , L)

CHAPTER 3 National Income slide 15

Part 2: Equilibrium in the factors market

 Equilibrium is where factor supply

equals factor demand.
 Recall: Supply of factors is fixed.
 Demand for factors comes from
firms.

CHAPTER 3 National Income slide 16

 Demand in factors market
Analyze the decision of a typical firm.
• It buys labor in the labor market,
where price is wage, W.
• It rents capital in the factors market,
at rate R.
• It uses labor and capital to produce
the good, which it sells in the goods
market, at price P.

CHAPTER 3 National Income slide 17

 Demand in factors market
Assume the market is competitive:
Each firm is small relative to the
market, so its actions do not affect
the market prices.
It takes prices in markets as given -
W,R, P.

CHAPTER 3 National Income slide 18

 Demand in factors market
It then chooses the optimal quantity of
Labor and capital to maximize its
profit.

How write profit:

Profit = revenue -labor costs -capital
costs
= PY - WL - RK
= P F(K,L) - WL - RK

CHAPTER 3 National Income slide 19

Demand in the factors market
 Increasing hiring of L will have two
effects:
1) Benefit: raise output by some amount
2) Cost: raise labor costs at rate W

 To see how much output rises, we need

the marginal product of labor (MPL)

CHAPTER 3 National Income slide 20

Marginal product of labor (MPL)
An approximate definition (used in
text) :
The extra output the firm can produce
using one additional labor (holding
other inputs fixed):
MPL = F (K, L +1) – F (K, L)

CHAPTER 3 National Income slide 21

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

MP Slope of the
L production function
1 equals MPL: rise
over run L
labo
CHAPTER 3 National Income r
slide 22
 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

CHAPTER 3 National Income slide 23

Return to firm problem: hiring L
Firm chooses L to maximize its profit.
How will increasing L change profit?
 profit =  revenue -  cost
= P * MPL - W
If this is: > 0 should hire more
< 0 should hire less
= 0 hiring right
amount

CHAPTER 3 National Income slide 24

 Firm problem continued
So the firm’s demand for labor is
determined by the condition:
P *MPL = W
Hires more and more L, until MPL falls
enough to satisfy the condition.

Also may be written:

MPL = W/P, where W/P is the ‘real wage’

CHAPTER 3 National Income slide 25

 Real wage
Think about units:
 W = $/hour
 P = $/good
 W/P = ($/hour) / ($/good) =
goods/hour
The amount of purchasing power,
measured in units of goods, that firms
pay per unit of work

CHAPTER 3 National Income slide 26

MPL and the demand for labor
labor supply
Units of
output Each
Eachfirm
firmhires
hireslabor
labor
up
uptotothe
thepoint
pointwhere
where
 MPL
MPL == W/P
W/P
Real
wag
e 
MPL,
Labor
demand
L Units of labor,
L

CHAPTER 3 National Income slide 27

 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 .

CHAPTER 3 National Income slide 28

 How income is distributed:
We found that if markets are competitive,
then factors of production will be paid
their marginal contribution to the
production process.
W
total labor income = L MPL L
P

R
total capital income = K MPK K
P

CHAPTER 3 National Income slide 29

 Euler’s theorem:
Under our assumptions (constant returns to
scale, profit maximization, and competitive
markets)…
total output is divided between the
payments to capital and labor, depending
on their marginal productivities, with no
extra profit
Y left over.
MPL L  MPK K

national labor capital

income income income

CHAPTER 3 National Income slide 30

 Outline of model
A closed economy, market-clearing
model
DONE  market:
Goods
Next  Supply side: production
 Demand side: C, I, and G

 market
Factors
DONE
Supply side
DONE 
 Demand side
Loanable funds market
 Supply side: saving
 Demand side: borrowing

CHAPTER 3 National Income slide 31

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 )

CHAPTER 3 National Income slide 32

 Consumption, C
 def: disposable income is total income minus
total taxes: Y–T
 Consumption function: C = C (Y – T ), the
relationship between consumption and disposable
income is called consumption function.
Shows that (Y – T )  C
 def: The marginal propensity to consume
(MPC) is the increase in C caused by an increase
in disposable income.
 So MPC = derivative of the consumption function
with respect to disposable income.
 MPC must be between 0 and 1.

CHAPTER 3 National Income slide 33

 The consumption function
C

C (Y –
T)

The slope of the

rise
consumption
r function is the
u MPC.
n
Y–T

CHAPTER 3 National Income slide 34

 Consumption function cont.
Suppose consumption function:
C=10 + 0.75Y
MPC = 0.75
For extra dollar of income, spend
0.75 dollars consumption
Marginal propensity to save = 1-
MPC

CHAPTER 3 National Income slide 35

 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

CHAPTER 3 National Income slide 36

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

I
(r )
I

CHAPTER 3 National Income slide 37

 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

CHAPTER 3 National Income slide 38

The market for goods & services

 Agg. demand: C (Y  T )  I (r )  G

 Agg. supply: Y F (K , L)

 Equilibrium: Y = C (Y  T )  I (r )  G

The
The real
real interest
interest rate
rate adjusts
adjusts
to
to equate
equate demand
demand with
with supply.
supply.
We can get more intuition for how this works
by looking at the loanable funds market

CHAPTER 3 National Income slide 39

 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 40

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).

CHAPTER 3 National Income slide 41

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

I
(r )
I

CHAPTER 3 National Income slide 42

 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 43
 Types of saving
 private saving (sp) = (Y –T ) – C
 government saving (sg) = T
–G
 national saving, S
= sp + sg
= (Y –T ) – C + T–G
= Y – C – G

CHAPTER 3 National Income slide 44

 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.

CHAPTER 3 National Income slide 45

 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

CHAPTER 3 National Income slide 46

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

Equilibrium real
interest rate

I (r )
Equilibrium level S, I
of investment

CHAPTER 3 National Income slide 47

 The special role of r
rr adjusts
adjusts toto equilibrate
equilibrate the
the goods
goods market
market
and
and the
the loanable
loanable funds
funds market
market
simultaneously:
simultaneously:
IfIf L.F.
L.F. market
market inin equilibrium,
equilibrium, then
then
YY –– CC –– G
G =
= II
Add
Add (C
(C +G
+G )) to
to both
both sides
sides to
to get
get
YY= =C
C+ + II +
+GG (goods
(goods market
market eq’m)
eq’m)
Thus,
Eq’m in
Thus, L.F.  Eq’m in
goods
market market
CHAPTER 3 National Income slide 48
Mastering the loanable funds model
Things that shift the saving curve
a. public saving
i. fiscal policy: changes in G or T
b. private saving
i. preferences
ii. tax laws that affect saving (401(k),
IRA)

CHAPTER 3 National Income slide 49

 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 50

 Chapter summary
4. The economy’s output is used for
 consumption
(which depends on disposable income)
 Investment
(depends on 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

6. A decrease in national saving causes the

interest rate to rise and investment to fall.

CHAPTER 3 National Income slide 51