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MACROECONOMICS
C H A P T E R
© 2008 Worth Publishers, all rights reserved
SIXTH EDITION
PowerPoint®
Slides by Ron Cronovich
N. GREGORY MANKIW
National Income:
Where it Comes From
and Where it Goes
3
slide 1
CHAPTER 3 National Income
In this chapter, you will learn…
 what determines the economy’s total
output/income
 how the prices of the factors of production are
determined
 how total income is distributed
 what determines the demand for goods and
services
 how equilibrium in the goods market is achieved
slide 2
CHAPTER 3 National Income
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
slide 3
CHAPTER 3 National Income
Factors of production
K = capital:
tools, machines, and structures used in
production
L = labor:
the physical and mental efforts of
workers
slide 4
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 economy’s level of technology
 exhibits constant returns to scale
slide 5
CHAPTER 3 National Income
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
slide 6
CHAPTER 3 National Income
Example 1
( , )
F K L KL

( , ) ( )( )
F zK zL zK zL

z KL
 2
z KL
 2
z KL

( , )
z F K L

constant returns to
scale for any z > 0
slide 7
CHAPTER 3 National Income
Example 2
( , )
F K L K L
 
( , )
F zK zL zK zL
 
z K z L
 
( , )
z F K L

decreasing
returns to scale
for any z > 1
 
z K L
 
slide 8
CHAPTER 3 National Income
Example 3
( , )
F K L K L
 
2 2
( , ) ( ) ( )
F zK zL zK zL
 
2 2
( , )
z F K L
 2 increasing returns
to scale for any
z > 1
 
z K L
 
2 2 2
slide 12
CHAPTER 3 National Income
Assumptions of the model
1. Technology is fixed.
2. The economy’s supplies of capital and labor
are fixed at
and
K K L L
 
slide 13
CHAPTER 3 National Income
Determining GDP
Output is determined by the fixed factor supplies
and the fixed state of technology:
,
 ( )
Y F K L
slide 14
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
slide 15
CHAPTER 3 National Income
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
slide 16
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?
slide 17
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
slide 18
CHAPTER 3 National Income
Marginal product of labor (MPL)
 definition:
The extra output the firm can produce
using an additional unit of labor
(holding other inputs fixed):
MPL = F(K,L+1) – F(K,L)
slide 21
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
slide 22
CHAPTER 3 National Income
Y
output
MPL and the production function
L
labor
F K L
( , )
1
MPL
1
MPL
1
MPL
As more labor is
added, MPL 
Slope of the production
function equals MPL
slide 25
CHAPTER 3 National Income
MPL and the demand for labor
Each firm hires labor
up to the point where
MPL = W/P.
Units of
output
Units of labor, L
MPL,
Labor
demand
Real
wage
Quantity of labor
demanded
slide 26
CHAPTER 3 National Income
The equilibrium real wage
The real wage
adjusts to equate
labor demand
with supply.
Units of
output
Units of labor, L
MPL,
Labor
demand
equilibrium
real wage
Labor
supply
L
slide 27
CHAPTER 3 National Income
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.
slide 28
CHAPTER 3 National Income
The equilibrium real rental rate
The real rental rate
adjusts to equate
demand for capital
with supply.
Units of
output
Units of capital, K
MPK,
demand for
capital
equilibrium
R/P
Supply of
capital
K
slide 29
CHAPTER 3 National Income
The Neoclassical Theory
of Distribution
 states that each factor input is paid its marginal
product
 is accepted by most economists
slide 30
CHAPTER 3 National Income
How income is distributed:
total labor income =
If production function has constant returns to
scale, then
total capital income =
W
L
P
MPL L
 
R
K
P
MPK K
 
Y MPL L MPK K
   
labor
income
capital
income
national
income
slide 31
CHAPTER 3 National Income
The ratio of labor income to total
income in the U.S.
0
0.2
0.4
0.6
0.8
1
1960 1970 1980 1990 2000
Labor’s
share
of total
income
Labor’s share of income
is approximately constant over time.
(Hence, capital’s share is, too.)
slide 32
CHAPTER 3 National Income
The Cobb-Douglas Production
Function
 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
 The Cobb-Douglas production function is:
where A represents the level of technology.
1
Y AK L
  
slide 34
CHAPTER 3 National Income
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
DONE 
DONE 
Next 
slide 35
CHAPTER 3 National Income
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 )
slide 36
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.
slide 37
CHAPTER 3 National Income
The consumption function
C
Y – T
C(Y –T )
1
MPC
The slope of the
consumption function
is the MPC.
slide 38
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 one’s own
funds to finance investment spending.
So, r  I
slide 39
CHAPTER 3 National Income
The investment function
r
I
I(r)
Spending on
investment goods
depends negatively on
the real interest rate.
slide 40
CHAPTER 3 National Income
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:
and
G G T T
 
slide 41
CHAPTER 3 National Income
The market for goods & services
 Aggregate demand:
 Aggregate supply:
 Equilibrium:
 The real interest rate adjusts
to equate demand with supply.
  
( ) ( )
C Y T I r G
 ( , )
Y F K L
  
= ( ) ( )
Y C Y T I r G
slide 42
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
slide 43
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).
slide 44
CHAPTER 3 National Income
Loanable funds demand curve
r
I
I(r)
The investment
curve is also the
demand curve for
loanable funds.
slide 45
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.
slide 46
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
slide 50
CHAPTER 3 National Income
digression:
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.
slide 51
CHAPTER 3 National Income
U.S. Federal Government
Surplus/Deficit, 1940-2005
-30%
-25%
-20%
-15%
-10%
-5%
0%
5%
1940 1950 1960 1970 1980 1990 2000
(%
of
GDP)
slide 52
CHAPTER 3 National Income
U.S. Federal Government Debt,
1940-2005
0%
20%
40%
60%
80%
100%
120%
1940 1950 1960 1970 1980 1990 2000
(%
of
GDP)
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.)
slide 53
CHAPTER 3 National Income
Loanable funds supply curve
r
S, I
( )
S Y C Y T G
   
National saving
does not
depend on r,
so the supply
curve is vertical.
slide 54
CHAPTER 3 National Income
Loanable funds market
equilibrium
r
S, I
I(r)
( )
S Y C Y T G
   
Equilibrium real
interest rate
Equilibrium level
of investment
slide 55
CHAPTER 3 National Income
The special role of r
r adjusts to equilibrate the goods market and the
loanable funds market simultaneously:
If L.F. 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

slide 58
CHAPTER 3 National Income
CASE STUDY:
The Reagan deficits
 Reagan policies during early 1980s:
 increases in defense spending: G > 0
 big tax cuts: T < 0
 Both policies reduce national saving:
( )
S Y C Y T G
   
G S
   T C S
    
slide 59
CHAPTER 3 National Income
CASE STUDY:
The Reagan deficits
r
S, I
1
S
I(r)
r1
I1
r2
2. …which causes
the real interest
rate to rise…
I2
3. …which reduces
the level of
investment.
1. The increase in
the deficit
reduces saving…
2
S
slide 60
CHAPTER 3 National Income
Are the data consistent with these results?
variable 1970s 1980s
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.
slide 62
CHAPTER 3 National Income
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
slide 63
CHAPTER 3 National Income
An increase in investment demand
An increase
in desired
investment…
r
S, I
I1
S
I2
r1
r2
…raises the
interest rate.
But the equilibrium
level of investment
cannot increase
because the
supply of loanable
funds is fixed.
slide 64
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?
slide 65
CHAPTER 3 National Income
An increase in investment demand
when saving depends on r
r
S, I
I(r)
( )
S r
I(r)2
r1
r2
An increase in
investment demand
raises r,
which induces an
increase in the
quantity of saving,
which allows I
to increase.
I1 I2
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 66
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 67
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 68

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National Income National Income National Income

  • 1. MACROECONOMICS C H A P T E R © 2008 Worth Publishers, all rights reserved SIXTH EDITION PowerPoint® Slides by Ron Cronovich N. GREGORY MANKIW National Income: Where it Comes From and Where it Goes 3
  • 2. slide 1 CHAPTER 3 National Income In this chapter, you will learn…  what determines the economy’s total output/income  how the prices of the factors of production are determined  how total income is distributed  what determines the demand for goods and services  how equilibrium in the goods market is achieved
  • 3. slide 2 CHAPTER 3 National Income 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
  • 4. slide 3 CHAPTER 3 National Income Factors of production K = capital: tools, machines, and structures used in production L = labor: the physical and mental efforts of workers
  • 5. slide 4 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 economy’s level of technology  exhibits constant returns to scale
  • 6. slide 5 CHAPTER 3 National Income 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
  • 7. slide 6 CHAPTER 3 National Income Example 1 ( , ) F K L KL  ( , ) ( )( ) F zK zL zK zL  z KL  2 z KL  2 z KL  ( , ) z F K L  constant returns to scale for any z > 0
  • 8. slide 7 CHAPTER 3 National Income Example 2 ( , ) F K L K L   ( , ) F zK zL zK zL   z K z L   ( , ) z F K L  decreasing returns to scale for any z > 1   z K L  
  • 9. slide 8 CHAPTER 3 National Income Example 3 ( , ) F K L K L   2 2 ( , ) ( ) ( ) F zK zL zK zL   2 2 ( , ) z F K L  2 increasing returns to scale for any z > 1   z K L   2 2 2
  • 10. slide 12 CHAPTER 3 National Income Assumptions of the model 1. Technology is fixed. 2. The economy’s supplies of capital and labor are fixed at and K K L L  
  • 11. slide 13 CHAPTER 3 National Income Determining GDP Output is determined by the fixed factor supplies and the fixed state of technology: ,  ( ) Y F K L
  • 12. slide 14 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
  • 13. slide 15 CHAPTER 3 National Income 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
  • 14. slide 16 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?
  • 15. slide 17 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
  • 16. slide 18 CHAPTER 3 National Income Marginal product of labor (MPL)  definition: The extra output the firm can produce using an additional unit of labor (holding other inputs fixed): MPL = F(K,L+1) – F(K,L)
  • 17. slide 21 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
  • 18. slide 22 CHAPTER 3 National Income Y output MPL and the production function L labor F K L ( , ) 1 MPL 1 MPL 1 MPL As more labor is added, MPL  Slope of the production function equals MPL
  • 19. slide 25 CHAPTER 3 National Income MPL and the demand for labor Each firm hires labor up to the point where MPL = W/P. Units of output Units of labor, L MPL, Labor demand Real wage Quantity of labor demanded
  • 20. slide 26 CHAPTER 3 National Income The equilibrium real wage The real wage adjusts to equate labor demand with supply. Units of output Units of labor, L MPL, Labor demand equilibrium real wage Labor supply L
  • 21. slide 27 CHAPTER 3 National Income 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.
  • 22. slide 28 CHAPTER 3 National Income The equilibrium real rental rate The real rental rate adjusts to equate demand for capital with supply. Units of output Units of capital, K MPK, demand for capital equilibrium R/P Supply of capital K
  • 23. slide 29 CHAPTER 3 National Income The Neoclassical Theory of Distribution  states that each factor input is paid its marginal product  is accepted by most economists
  • 24. slide 30 CHAPTER 3 National Income How income is distributed: total labor income = If production function has constant returns to scale, then total capital income = W L P MPL L   R K P MPK K   Y MPL L MPK K     labor income capital income national income
  • 25. slide 31 CHAPTER 3 National Income The ratio of labor income to total income in the U.S. 0 0.2 0.4 0.6 0.8 1 1960 1970 1980 1990 2000 Labor’s share of total income Labor’s share of income is approximately constant over time. (Hence, capital’s share is, too.)
  • 26. slide 32 CHAPTER 3 National Income The Cobb-Douglas Production Function  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  The Cobb-Douglas production function is: where A represents the level of technology. 1 Y AK L   
  • 27. slide 34 CHAPTER 3 National Income 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 DONE  DONE  Next 
  • 28. slide 35 CHAPTER 3 National Income 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 )
  • 29. slide 36 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.
  • 30. slide 37 CHAPTER 3 National Income The consumption function C Y – T C(Y –T ) 1 MPC The slope of the consumption function is the MPC.
  • 31. slide 38 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 one’s own funds to finance investment spending. So, r  I
  • 32. slide 39 CHAPTER 3 National Income The investment function r I I(r) Spending on investment goods depends negatively on the real interest rate.
  • 33. slide 40 CHAPTER 3 National Income 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: and G G T T  
  • 34. slide 41 CHAPTER 3 National Income The market for goods & services  Aggregate demand:  Aggregate supply:  Equilibrium:  The real interest rate adjusts to equate demand with supply.    ( ) ( ) C Y T I r G  ( , ) Y F K L    = ( ) ( ) Y C Y T I r G
  • 35. slide 42 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
  • 36. slide 43 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).
  • 37. slide 44 CHAPTER 3 National Income Loanable funds demand curve r I I(r) The investment curve is also the demand curve for loanable funds.
  • 38. slide 45 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.
  • 39. slide 46 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
  • 40. slide 50 CHAPTER 3 National Income digression: 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.
  • 41. slide 51 CHAPTER 3 National Income U.S. Federal Government Surplus/Deficit, 1940-2005 -30% -25% -20% -15% -10% -5% 0% 5% 1940 1950 1960 1970 1980 1990 2000 (% of GDP)
  • 42. slide 52 CHAPTER 3 National Income U.S. Federal Government Debt, 1940-2005 0% 20% 40% 60% 80% 100% 120% 1940 1950 1960 1970 1980 1990 2000 (% of GDP) 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.)
  • 43. slide 53 CHAPTER 3 National Income Loanable funds supply curve r S, I ( ) S Y C Y T G     National saving does not depend on r, so the supply curve is vertical.
  • 44. slide 54 CHAPTER 3 National Income Loanable funds market equilibrium r S, I I(r) ( ) S Y C Y T G     Equilibrium real interest rate Equilibrium level of investment
  • 45. slide 55 CHAPTER 3 National Income The special role of r r adjusts to equilibrate the goods market and the loanable funds market simultaneously: If L.F. 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 
  • 46. slide 58 CHAPTER 3 National Income CASE STUDY: The Reagan deficits  Reagan policies during early 1980s:  increases in defense spending: G > 0  big tax cuts: T < 0  Both policies reduce national saving: ( ) S Y C Y T G     G S    T C S     
  • 47. slide 59 CHAPTER 3 National Income CASE STUDY: The Reagan deficits r S, I 1 S I(r) r1 I1 r2 2. …which causes the real interest rate to rise… I2 3. …which reduces the level of investment. 1. The increase in the deficit reduces saving… 2 S
  • 48. slide 60 CHAPTER 3 National Income Are the data consistent with these results? variable 1970s 1980s 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.
  • 49. slide 62 CHAPTER 3 National Income 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
  • 50. slide 63 CHAPTER 3 National Income An increase in investment demand An increase in desired investment… r S, I I1 S I2 r1 r2 …raises the interest rate. But the equilibrium level of investment cannot increase because the supply of loanable funds is fixed.
  • 51. slide 64 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?
  • 52. slide 65 CHAPTER 3 National Income An increase in investment demand when saving depends on r r S, I I(r) ( ) S r I(r)2 r1 r2 An increase in investment demand raises r, which induces an increase in the quantity of saving, which allows I to increase. I1 I2
  • 53. 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 66
  • 54. 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 67
  • 55. 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 68