N.

Gregory Mankiw

Macroeconomics

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

CHAPTER 3 National Income slide 1

 In this chapter, you will learn…

▪ How an economy’s total output/income is

produced
▪ How the prices of the factors of production
are determined
▪ How total income is distributed
▪ What determines the demand for goods and
services (how is total income spent?)
▪ How equilibrium in the goods market is
achieved
CHAPTER 3 National Income slide 2
 Outline of model
A closed economy, market-clearing model

Economic Agents (A person, company etc that has an effect

on the economy of a country, for example by buying, selling,
or investing )
▪ Households
▪ Firms
▪ Government

Markets where these agents interact

▪ Market for Goods and Services
▪ Factor Markets
▪ Financial Markets

The interaction between agents in the context of

markets determines an economy’s resource
allocation and progress slide 3
The Flow of Dollar

CHAPTER 3 National Income slide 4

 Who Produces Output?
Basic Classical Model
• This model begins with firms and look at how
much do the firms in the economy produce?
What determines a nation’s total income?
• Then, the model examines how the markets
for the factors of production distribute this
income to households. Who gets the income
from production? How much goes to
compensate workers, and how much goes to
compensate owners of capital?
• Next, the model considers how much of this
income households consume and how much
they save.
CHAPTER 3 National Income slide 5
 Who Produces Output?
Basic Classical Model
• Then it discusses demand of goods and
services arising from the consumption by
households and from investment and
government purchases.
• It looks at questions like who buys the output
of the economy? How much do households
purchase for consumption, how much do
households and firms purchase for
investment, and how much does the
government buy for public purposes?

CHAPTER 3 National Income slide 6

 Who Produces Output?
Basic Classical Model
• Finally, the model examine how the demand
for goods and services (the sum of
consumption, investment, and government
purchases) and the supply of goods and
services (the level of production) are brought
into balance.
• What equilibrates the demand for and supply
of goods and services? What ensures that
desired spending on consumption,
investment, and government purchases
equals the level of production?

CHAPTER 3 National Income slide 7

 Who Determines Total Output?
Factors of production
• Factors of production are the inputs used to
produce goods and services.
• The most two important factors of
production are capital and labor.
• Capital is the set of tools that workers use:
the construction worker’s crane, the
accountant’s calculator, the manager’s
computer, etc.
• Labor is the time people spend working.

CHAPTER 3 National Income slide 8

 Who Determines Total Output?
Factors of production
We use the symbol K to denote the amount
of capital and the symbol L to denote
the labor.
K = capital:
tools, machines, and structures used in production
(the construction worker’s crane, the accountant’s
calculator, manager’s personal computer)

L = labor:
the physical and mental efforts of workers (time
people spend working)

AND

TECHNOLOGY
CHAPTER 3 National Income slide 9
 Who Determines Total Output?
Factors of production
• Assumptions of the basic model
• The economy has a fixed amount of capital
and a fixed amount of labor
• The factors of production are fully utilized
• K=K and L=L : the overbar means that
each variable is fixed at some level. This
assumption is made in order to keep the
analysis simple.
• It is also assumed that the factors of
production are fully utilized – that is no
resources is wasted. However, this is not
CHAPTER 3 National Income slide 10
the case in the real world.
 The production function
▪ The available production technology determines
how much output is produced from given
amounts of capital and labor.
▪ This relationship is expressed using a
production function as shown below:
▪ denoted Y = F(K, L)
▪ shows how much output (Y ) the economy can
produce from K units of capital and L units of
labor
slide 11
 The production function
Constant Returns to Scale
▪ Many production functions have a property
called constant returns to scale.
▪ A production function has constant returns to
scale if an increase in equal percentage in all
factors of production cause an increase in
output of the same percentage.

slide 12
 The production function
Constant Returns to Scale
▪ For example, when constant returns to scale
exists, then 10% increase in all factors of
production will result in 10% increase in output.
▪ If Y=F (K,L), Then a production function has
constant returns to scale if zY=F (zK, zL) for
any positive number of z.

slide 13
 Returns to scale: A review
Initially Y1 = F (K1 , L1 )
Suppose all inputs were to increase by the same factor z:
K2 = zK1 and L2 = zL1
(e.g., if z = 2, then all inputs are doubled)
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 14

 Example 1

constant returns to
scale for any z > 0
CHAPTER 3 National Income slide 15
 Example 2

decreasing
returns to scale
for any z > 1

CHAPTER 3 National Income slide 16

 Example 3

increasing
returns to scale
for any
z>1

CHAPTER 3 National Income slide 17

 Now you try…

▪ Determine whether constant, decreasing, or

increasing returns to scale for each of these
production functions:

(a)

(b)

CHAPTER 3 National Income slide 18

 Answer to part (a)

constant returns to
scale for any z > 0
CHAPTER 3 National Income slide 19
 Answer to part (b)

constant returns to
scale for any z > 0

CHAPTER 3 National Income slide 20

 Assumptions of the model
1. Technology is fixed.

2. The economy’s supplies of capital and labor

are fixed at

Why? Because we are looking at the “long run”

where all resources are fully utilized or
employed

CHAPTER 3 National Income slide 21

 Determining GDP: The Supply of
Goods and Services
If we assume that the supplies of capital, labor
and technology is fixed, then output is also fixed
and is determined by the fixed factor supplies
and the fixed state of technology:

CHAPTER 3 National Income slide 22

 The distribution of national
income
▪ The total output of an economy equals its total
income.
▪ Since factors of production and production
function together determine the total output;
they also determine income.
▪ The circular flow shows that this income flows
from firms to households through the market
for the factors of production.

CHAPTER 3 National Income slide 23

 The distribution of national
income
▪ Here, the model examines the modern theory of
how national income is divided among the
factors of production.
▪ It is based on the classical (eighteenth century)
idea that prices adjust to balance supply and
demand and the neo-classical theory
(nineteenth-century) that the demand for each
factor of production depends on the marginal
productivity of that factor.
CHAPTER 3 National Income slide 24
 The distribution of national
income
▪ The distribution of national income is
determined by factor prices,
▪ Factor prices are the prices per unit of factors
that firms pay.
▪ In an economy, where the two factors of
production are capital and labor, the two factor
prices are the wages workers earn and the
rent of capital the owners collect.
▪ wage = price of L
▪ rental rate = price of K slide 25
 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

CHAPTER 3 National Income slide 26

 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 of factors?
▪ Demand of factors arises from the thousands of
firms that use capital and labor.
▪ Therefore understanding of demand depends
on understanding of how a typical firm makes
decision about how much of these factors to slide 27
How factor prices are
determined

slide 28
 The Decisions Facing the
Competitive Firm
▪ It is assumed that a typical firm is competitive.
▪ A competitive firm is small relative to the
markets in which it trades, so it has little
influence on market prices of goods and
services, and labor.
▪ The firm sells its output at price P, hires workers
at a wage W, and rents capital at a rate R.
▪ In this analysis, the households rent out their
capital, just as they sell labor.
slide 29
 The Decisions Facing the
Competitive Firm
▪ The goal of a firm is to make profit.
▪ Profit is equal to revenue minus costs.
▪ Now,
▪ P = Price of output
▪ Y = Quantity of output
▪ W = Price of labor
▪ R = Rent of capital
▪ L = Amount of Labor
▪ K = Amount of Capital slide 30
 The Decisions Facing the
Competitive Firm
▪ Then Profit = Revenue – Labor Costs – Capital
Costs
= PY – WL – RK
The production function is Y=F(K,L)
So we have,
Profit = P*F(K,L) – WL – RK

The competitive firm takes the product price and

the factor prices as given (as it has little
influence on the market) and chooses the
amounts of labor and capital that maximize
slide 31
 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

CHAPTER 3 National Income slide 32

 Marginal product of labor (MPL )

▪ definition:
The extra output the firm can produce
using an additional unit of labor (or capital)
(holding all other inputs fixed):
MPL = F (K, L +1) – F (K, L)

CHAPTER 3 National Income slide 33

 Exercise: Compute & graph MPL
L Y MPL
a. Determine MPL at each
0 0 n.a.
value of L.
1 10 ?
b. Graph the production 2 19 ?
function. 3 27 8
4 34 ?
c. Graph the MPL curve
5 40 ?
with MPL on the vertical
6 45 ?
axis and
7 49 ?
L on the horizontal axis.
8 52 ?
9 54 ?
10 55 ?
CHAPTER 3 National Income slide 34
 Answers:

Most production functions have the property of diminishing marginal product:

holding the amount of capital fixed, the marginal product of labor decreases as
the amount of labor increases.
CHAPTER 3 National Income slide 35
 MPL and the production function
Y
output

MP
1 L As more labor
MP is added, MPL
L ↓
1

Slope of the
MP
L production function
equals MPL
1
L
labor
CHAPTER 3 National Income slide 36
 Diminishing marginal returns

▪ As a factor input is increased,

its marginal product falls (other things equal).
▪ For example, holding the amount of capital
fixed, the marginal product of labor decreases as
the amount of labor increases.
▪ Intuition:
Suppose ↑L while holding K fixed
⇒ fewer machines per worker
⇒ lower worker productivity
CHAPTER 3 National Income slide 37
 Diminishing marginal returns
Consider again the production of bread at a bakery.

As a bakery hires more labor, it produces more bread.

The MPL is the amount of extra bread produced when
an extra unit of labor is hired. As more labor is added to a
fixed amount of capital, however, the MPL falls. Fewer
additional loaves are produced because workers are less
productive when the kitchen is more crowded. In other
words, holding the size of the kitchen fixed, each
additional worker adds fewer loaves of bread to the
bakery’s output

CHAPTER 3 National Income slide 38

 Check your understanding:

▪ Which of these production functions have

diminishing marginal returns to labor?

CHAPTER 3 National Income slide 39

 From MPL to Labor Demand

• MPL = Units of output an extra unit of labor

produces
• P = Price of Output
• W = Price of Labor (Wage)
• The change in profit from hiring an additional labor
is
∆ Profit = ∆ Revenue - ∆ Cost
= (P X MPL) - W

CHAPTER 3 National Income slide 40

 From MPL to Labor Demand

• So the firm will continue to employ additional unit

of labor as long as P X MPL >= W i.e., will not
employ additional labor when P X MPL < W.
• Therefore, the competitive demand for labor is
determined by
• P X MPL = W

• Or, MPL = W/P

• W/P is the real wage.

• So, to maximize profits, the firm hires labor up to the

point at which the marginal product of labor equals
the real wage.
slide 41
 Exercise (part 2) L Y
MPL
0 0 n.a.
Suppose W/P = 6.
1 10 10
a. If L = 3, should firm hire 2 19 9
more or less labor? Why? 3 27 8
b. If L = 7, should firm hire 4 34 7
more or less labor? Why? 5 40 6
6 45 5
7 49 4
8 52 3
9 54 2
10 55 1
CHAPTER 3 National Income slide 42
 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

CHAPTER 3 National Income slide 43

 The equilibrium real wage
Units of Labor
output The real wage
supply
adjusts to equate
labor demand
with supply.

equilibriu
m real MPL,
wage Labor
demand
Units of labor, L

CHAPTER 3 National Income slide 44

 Determining the rental rate
We have just seen that MPL = W/P.

The same logic shows that MPK = R/P :

R/P is the real rental rate.
▪ 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 45

 The equilibrium real rental rate
Units of
output Supply of The real rental rate
capital adjusts to equate
demand for capital
with supply.

equilibriu
m R/P MPK,
demand for
capital
Units of capital, K

CHAPTER 3 National Income slide 46

 The equilibrium real factor price

To sum up, the competitive, profit maximizing firm follows a simple rule about
how much labor to hire and how much capital to rent.

The firm demands each factor of production until that factor’s marginal
slide 47
product falls to equal its real factor price.
 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.)

CHAPTER 3 National Income slide 48

 The Division of National Income

▪ The income that remains after the firms have

paid the factors of production is the economic
profit.
▪ Real economic profit=Y – (MPLXL) – (MPKXK)
▪ Y=(MPL X L) + (MPK X K) + Economic Profit
▪ = Labor’s share of income + Capital’s share of
income + Economic profit
▪ Y, total income, is divided among the return to
labor, return to capital and economic profit.
CHAPTER 3 National Income slide 49
 The Division of National Income

▪ In the real world, most firms own rather than

rent the capital they use.
▪ In such case, firm owners and capital owners are
the same people.
▪ The accounting profit of the firms is given by

Accounting Profit = Economic Profit + (MPK X K)

CHAPTER 3 National Income slide 50

 The Division of National Income
▪ When we have
Y = (MPL X L) + (MPK X K) + Economic Profit

▪ Under the assumptions of

▪ Constant returns to scale
▪ Profit maximization
▪ Competitive firm
Then, Economic profit is zero i.e., nothing is left
after the factors of production are paid ( derived from
Euler’s theorem).

▪ Therefore, total output/income is divided between the

payments to capital and the payments to labor, depending on
their marginal
CHAPTER productivities.
3 National Income slide 51
 The Cobb-Douglas Production
Function
▪ In case of constant factor share, the Cobb-
Douglas production function must have the
property that :

▪ Y = Total Income
▪ Capital Income = MPK X K = α Y and
▪ Labor Income = MPL X L = (1- α) Y
▪ Where α is a constant between zero and one
that measures capital’s share of income. That is,
α determines what share of income goes to
capital and what share goes to labor.
CHAPTER 3 National Income slide 52
 The Cobb-Douglas Production
Function
▪ The Cobb-Douglas function is the function with
this property

▪ where A is a parameter greater than zero and

represents the level/productivity of available
technology
▪ The Cobb-Douglas production function has
constant factor shares:
α = capital’s share of total income
(1- α ) = labor’s share of total income:
CHAPTER 3 National Income slide 53
 The Cobb-Douglas Production
Function

CHAPTER 3 National Income slide 54

 The Cobb-Douglas Production
Function
▪ Hence, when the production function is
Cobb-Douglas, then each factor’s marginal
product is proportional to its average product:

▪ Y/K – Average Capital Productivity

▪CHAPTER
Y/L –3Average Labor Productivity
National Income slide 55
 The Cobb-Douglas Production
Function
Since,

Therefore, MPK decreases as Capital (K)

increases.
Again,

Therefore, MPL decreases when Labor (L)

increases.

The factor shares depend only on the

parameter α.
CHAPTER 3 National Income slide 56
 How income is distributed:

total labor income =

total capital income =

If production function has constant returns

to scale, then

national labor capital

income income income

CHAPTER 3 National Income slide 57

 Empirical estimates of the Cobb-
Douglas Production Function

▪ Economists have estimated that the share of capital

income in U.S. GDP is approximately 33%, .i.e. α =
0.33
▪ Labor’s share in U.S. GDP is approximately 67%.
▪ These shares are roughly constant over long periods
of time: fits the Cobb-Douglas Specification.

CHAPTER 3 National Income slide 58

 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.)

CHAPTER 3 National Income slide 59

 The Neoclassical Theory
of Distribution
▪ The neoclassical theory of distribution tells us that
the real wage W/P equals the marginal product of
labor (MPL).
▪ The Cobb-Douglas function tells us that MPL is
proportional to average labor productivity (Y/L)
▪ If this theory is right, then workers should enjoy
rapidly rising incomes when labor productivity is
growing robustly. Is that true?

CHAPTER 3 National Income slide 60

 The Neoclassical Theory
of Distribution

CHAPTER 3 National Income slide 61

 The Neoclassical Theory in
Action…
Black Death and Factor Prices
▪ Outbreak of bubonic plague in Europe or The
Black Death in the year 1348
▪ The population of Europe was reduced by a third
▪ Real wages doubled and peasants enjoyed
economic prosperity
▪ More lands were unutilized or available for rent,
therefore, real rents on land fell by nearly 50
percent and the landowner class suffered
significant reductions in their incomes
CHAPTER 3 National Income slide 62
CHAPTER 3 National Income slide 63
 What Determines the Demand of
Goods and Services: Outline of
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

CHAPTER 3 National Income slide 64

 Demand for goods & services

A closed economy has three uses for the goods and

services it produces. These three components of
GDP are:
C = consumer demand for goods & services
I = firms’ demand for investment goods
G = government demand for goods & services
(closed economy: no exports or imports )

CHAPTER 3 National Income slide 65

 Gross Domestic Product, USA
[Billions of dollars]
Seasonally adjusted at annual rates
Source: Bureau of Economic Analysis

CHAPTER 3 National Income slide 66

 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.

▪ For example, if the MPC is 0.7, then households

spend 70 cents of each additional disposable
income on consumer goods and services and slide 67
 The consumption function
C

C (Y –T)

The slope of the

MPC
consumption
1 function is the MPC.

Y–T

CHAPTER 3 National Income slide 68

 Investment, I
▪ Investments by households include stock of
capital, new houses, etc.
▪ 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.
↑r ⇒Income
So,3 National
CHAPTER ↓I slide 69
 The investment function
r
Spending on
investment goods
depends negatively on
the real interest rate.

I (r )

CHAPTER 3 National Income slide 70

 Government spending, G

▪ Here, the model assumes government spending

and total taxes are exogenous and fixed:

CHAPTER 3 National Income slide 71

 The market for goods & services

▪ Aggregate demand:

▪ Aggregate supply:

▪ Equilibrium:

▪ At the equilibrium interest rate, the demand for

goods and services equal the supply.
CHAPTER 3 National Income slide 72
 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 73

 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).

CHAPTER 3 National Income slide 74

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

I (r )

CHAPTER 3 National Income slide 75

 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.

CHAPTER 3 National Income slide 76

 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

CHAPTER 3 National Income slide 77

 Loanable funds supply curve
r

National saving
depends on Y, T
and G, all of
which are fixed
and therefore
Supply curve is
a vertical line.

S, I

CHAPTER 3 National Income slide 78

 Loanable funds market
equilibrium

CHAPTER 3 National Income slide 79

 Notation: Δ = change in a variable

▪ For any variable X, ΔX = “the change in X ”

Δ is the Greek (uppercase) letter Delta

Examples:
▪ If ΔL = 1 and ΔK = 0, then ΔY = MPL.
More generally, if ΔK = 0, then

▪ Δ(Y−T ) = ΔY − ΔT , so
ΔC = MPC × (ΔY − ΔT )
= MPC ΔY − MPC ΔT
CHAPTER 3 National Income slide 80
 EXERCISE:
Calculate the change in saving

Suppose MPC = 0.8 and MPL = 20.

For each of the following, compute ΔS :
a . ΔG = 100
b. Δ T = 100
c . ΔY = 100
d. ΔL = 10

CHAPTER 3 National Income slide 81

 Answers

CHAPTER 3 National Income slide 82

 Budget surpluses and deficits
Transfer payments do affect the demand for goods and
services indirectly.
Transfer payments are the opposite of taxes: they
increase households’ disposable income, just as taxes
reduce disposable income.
Thus, an increase in transfer payments financed by an
increase in taxes leaves disposable income unchanged.

We can now revise our definition of T to equal taxes

minus transfer payments. Disposable income, Y − T,
includes both the negative impact of taxes and the
positive impact of transfer payments.

CHAPTER 3 National Income slide 83

 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 government finances its deficit by issuing
Treasury bonds – i.e., borrowing.

CHAPTER 3 National Income slide 84

 Changes in Savings: The Effects
of Fiscal Policy

▪ When government purchases increases:

▪ Increase in G => Increase in Demand for goods

and services

▪ But Total output is fixed by factors of

production. So, either consumption or
investment will decrease.

CHAPTER 3 National Income slide 85

 Changes in Savings: The Effects
of Fiscal Policy

▪ Since, output and taxes are fixed; therefore,

consumption remains unchanged.’

▪ Therefore, investment will decrease.

▪ A fall in investment will be matched by increase
in interest rate.

▪ So, increase in government purchase will result

in decrease in investment and increase in
interest rates. What will raise the interest rate?
CHAPTER 3 National Income slide 86
 Changes in Savings: The Effects
of Fiscal Policy

▪ Further, tax did not increase and so, increase in

government purchase will be matched with
increase in government borrowings:

▪ Then, public savings will decrease and

subsequently, the national savings will decrease.
With decrease in the national savings, the
interest rate will rise.

CHAPTER 3 National Income slide 87

 Changes in Savings: The Effects
of Fiscal Policy

▪ When taxes are decreased

▪ Now consider a reduction in taxes of ΔT. The
immediate impact of the tax cut is to raise
disposable income and thus to raise
consumption. Disposable income rises by ΔT,
and consumption rises by an amount
equal to ΔT times the marginal propensity to
consume MPC. The higher the
MPC, the greater the impact of the tax cut on
consumption.
CHAPTER 3 National Income slide 88
 Changes in Savings: The Effects
of Fiscal Policy

▪ Because the economy’s output is fixed by the

factors of production and the
level of government purchases is fixed by the
government, the increase in consumption must
be met by a decrease in investment. For
investment to fall, the
interest rate must rise. Hence, a reduction in
taxes, like an increase in government
purchases, crowds out investment and raises
the interest rate.
CHAPTER 3 National Income slide 89
 Changes in Savings: The Effects
of Fiscal Policy

▪ We can also analyze the effect of a tax cut by

looking at saving and investment. Because the
tax cut raises disposable income by ΔT,
consumption goes up
by MPC × ΔT. National saving S, which equals
Y - C - G, falls by the same
amount as consumption rises. As in Figure 3-9,
the reduction in saving shifts the
supply of loanable funds to the left, which
increases the equilibrium interest rate
and crowds
CHAPTER out
3 National investment
Income slide 90
 U.S. Federal Government Surplus/
Deficit, 1940-2004

CHAPTER 3 National Income slide 91

 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.)

CHAPTER 3 National Income slide 92

 The U.S. Budget Deficit: Where
is it Headed?
Year Actual or
Projected
(USD,
billions)

2002 157
2004 412
2006 248
2007 158*

2008 244*

2011 400*

CHAPTER 3 National Income slide 93

 "Over the long term, the budget
remains on an unsustainable path"
-Congressional Budget Office Report, 2007

▪ Continued military operations in Iraq and

Afghanistan
▪ Extension of temporary tax cuts enacted in
President Bush's first term
▪ Rising health-care and social security costs and
the retirement of the “baby-boom” generation
▪ Longer-term outlook is bleak.

CHAPTER 3 National Income slide 94

 The special role of r

r adjusts to equilibrate the goods market and the

loanable funds market simultaneously:
If Loanable Funds market is in equilibrium, then
Y–C–G =I
Y = C + I + G (goods market eq’m)
Thus,

Eq’m in L. Eq’m in goods

F. market market

CHAPTER 3 National Income slide 95

 CASE STUDY:
The Reagan deficits

▪ Reagan policies during early 1980s:

▪ increases in defense spending: ΔG > 0
▪ big tax cuts: ΔT < 0
▪ Both policies reduce national saving:

CHAPTER 3 National Income slide 96

 CASE STUDY:
The Reagan deficits
1. The increase in r
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.

CHAPTER 3 National Income slide 97

 Are the data consistent with these results?

variable 1970s1980s
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.

CHAPTER 3 National Income slide 98

 Military Spending and the Interest Rate
in the United Kingdom: 1730-1920

CHAPTER 3 National Income slide 99

 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 slide 100
 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
CHAPTER 3 National Income slide 101
 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?

CHAPTER 3 National Income slide 102

 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 slide 103

 An increase in investment demand
r

…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.
CHAPTER 3 National Income slide 104
 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?

CHAPTER 3 National Income slide 105

 An increase in investment demand
when saving depends on r
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)
I(r)
2

I I S, I
1 2
CHAPTER 3 National Income slide 106
 Chapter Summary

▪ 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 107
 Chapter Summary

▪ 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 108
 Chapter Summary

▪ 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 109