N.

Gregory Mankiw

Macroeconomics

Chapter 3:

National Income:
Where it Comes From
and Where it Goes

CHAPTER 3 National Income

In this chapter, you will learn

How an economys 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

Outline of model
A closed economy, market-clearing model
Economic Agents
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 economys resource
allocation and progress

CHAPTER 3 National Income

CHAPTER 3 National Income

Who Produces Output?

Factors of production
K =

capital:
tools, machines, and structures used in
production

L =

labor:
the physical and mental efforts of workers
AND
TECHNOLOGY

CHAPTER 3 National Income

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 economys level of technology
exhibits constant
constant returns to scale
scale

CHAPTER 3 National Income

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

Assumptions of the model

1. Technology is fixed.
2. The economys supplies of capital and labor

are fixed at

K K

and

LL

Why? Because we are looking at the long run

where all resources are fully utilized or
employed

CHAPTER 3 National Income

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

Y F (K , L)

CHAPTER 3 National Income

The distribution of 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

Notation
W

= nominal wage

= nominal rental rate

= price of output

W /P

= real wage
(measured in units of output)

R /P = real rental rate

CHAPTER 3 National Income

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?

CHAPTER 3 National Income

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

Marginal product of labor

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

CHAPTER 3 National Income

Answers:
Marginal Product of Labor
MPL (units of output)

Output (Y)

Production function
60
50
40
30
20
10

12
10
8
6
4
2
0

0
0

9 10

Labor (L)

CHAPTER 3 National Income

9 10

Labor (L)

MPL and the production function

Y
output
F (K , L )

1
1
MP
L

MP
L

MP
L

As more labor is
added, MPL

Slope of the production

function equals MPL

L
labor
CHAPTER 3 National Income

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

CHAPTER 3 National Income

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

The equilibrium real wage

Units of
output

Labor
supply

equilibriu
m real
wage
L

CHAPTER 3 National Income

The real wage

adjusts to equate
labor demand
with supply.

MPL,
Labor
demand
Units of labor, L

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 firms demand curve
for renting capital.

Firms maximize profits by choosing K

such that MPK = R/P .

CHAPTER 3 National Income

The equilibrium real rental rate

Units of
output

Supply of
capital

equilibriu
m R/P
K

CHAPTER 3 National Income

The real rental rate

adjusts to equate
demand for capital
with supply.

MPK,
demand for
capital
Units of capital, K

The Cobb-Douglas
Production Function
The Cobb-Douglas production function is:

Y AK L

where A represents the level of technology

The Cobb-Douglas production function
has constant factor shares:
= capitals share of total income:
capital income = MPK x K = Y
labor income = MPL x L = (1 )Y

.
CHAPTER 3 National Income

The Cobb-Douglas
Production Function
Each factors marginal product is
proportional to its average product:
Y
MPK AK L
K
(1 )Y

MPL (1 ) AK L
L
1

CHAPTER 3 National Income

How income is distributed:

total labor income = MPL L (1 )Y
total capital income = MPK K Y
If production function has constant returns to
scale, then

Y MPL L MPK K
national
income

labor
income
CHAPTER 3 National Income

capital
income

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. =
0.33

Labors share in U.S. GDP is approximately 67%.

These shares are roughly constant over long periods
of time: fits the Cobb-Douglas Specification.

Y AK

1/ 3

2/3

CHAPTER 3 National Income

The Neoclassical Theory

of Distribution
Each factor of production is paid its marginal
product

In equilibrium, MPL = W/P (real wage)

MPK = r/P (real rental rate)

Characterized by the Law of Diminishing Returns

Growth in factor productivity should be tracked by
the growth in real factor income.

CHAPTER 3 National Income

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
CHAPTER 3 National Income

Demand for goods &

services
Components of aggregate demand:

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

Gross Domestic Product

[Billions of dollars]
Seasonally adjusted at annual rates
Source: Bureau of Economic Analysis

CHAPTER 3 National Income

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.

CHAPTER 3 National Income

The consumption function

C

C (Y T)

MPC
1

The slope of the

consumption
function is the MPC.

YT

CHAPTER 3 National Income

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 ones own
funds to finance investment spending.
So, r I

CHAPTER 3 National Income

The investment function

r

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

I (r )
I
CHAPTER 3 National Income

Government spending, G
G = govt spending on goods and services.
Assume government spending and total
taxes are exogenous:
G G

and

T T

CHAPTER 3 National Income

The market for goods &

services
Aggregate demand:
Aggregate supply:
Equilibrium:

C (Y T ) I (r ) G
Y F (K , L )

Y = C (Y T ) I (r ) G

The real interest rate adjusts

to equate demand with supply.
CHAPTER 3 National Income

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

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

Loanable funds demand

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

I (r )
I
CHAPTER 3 National Income

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

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

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

Loanable funds market

equilibrium
r

S Y C (Y T ) G

Equilibrium
real interest
rate

I (r )
S, I

Equilibrium level
of investment
CHAPTER 3 National Income

Notation: = change in a variable

For any variable X, X = the change in X

is the Greek (uppercase) letter Delta

Examples:

If L = 1 and K = 0, then Y = MPL.

Y
More generally, if K = 0, then MPL
.
L
(YT ) = Y T , so

= MPC (Y T )
= MPC Y MPC T
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

Answers
S Y C G

Y 0.8 (Y T ) G

0.2 Y 0.8 T G

a. S 100

b. S 0.8 100 80
c. S 0.2 100 20

d. Y MPL L 20 10 200,
S 0.2 Y 0.2 200 40.
CHAPTER 3 National Income

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

An increase in investment demand

r
raises the
interest rate.

r2

An increase
in desired
investment

r1
But the equilibrium
level of investment
cannot increase
because the
supply of loanable
funds is fixed.

I1

I2

S, I

CHAPTER 3 National Income

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

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 I
to increase.

S (r )

r2
r1
I(r)
I(r)
2
I1 I2
CHAPTER 3 National Income

S, I