CHAPTER

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

MACROECONOMICS SIXTH EDITION

N. GREGORY MANKIW
PowerPoint® Slides by Ron Cronovich
© 2007 Worth Publishers, all rights reserved
 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
CHAPTER 3 National Income slide 1
 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

CHAPTER 3 National Income slide 2

 Factors of production

K = capital:
tools, machines, and structures used in
production
L = labor:
the physical and mental efforts of workers

CHAPTER 3 National Income slide 3

 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

CHAPTER 3 National Income slide 4

 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
CHAPTER 3 National Income slide 5
 Example 1

constant returns to
scale for any z > 0
CHAPTER 3 National Income slide 6
 Example 2

decreasing
returns to scale
for any z > 1

CHAPTER 3 National Income slide 7

 Example 3

increasing returns
to scale for any
z>1

CHAPTER 3 National Income slide 8

 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 9

 Answer to part (a)

constant returns to
scale for any z > 0
CHAPTER 3 National Income slide 10
 Answer to part (b)

constant returns to
scale for any z > 0

CHAPTER 3 National Income slide 11

 Assumptions of the model
1. Technology is fixed.
2. The economy’s supplies of capital and labor
are fixed at

CHAPTER 3 National Income slide 12

 Determining GDP

Output is determined by the fixed factor supplies

and the fixed state of technology:

CHAPTER 3 National Income slide 13

 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 slide 14

 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

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 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 slide 16

 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 17

 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)

CHAPTER 3 National Income slide 18

 Exercise: Compute & graph MPL

a. Determine MPL at each L Y MPL

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

CHAPTER 3 National Income slide 20

 MPL and the production function
Y
output

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

Slope of the production

MPL
function equals MPL
1
L
labor
CHAPTER 3 National Income slide 21
 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 slide 22

 Check your understanding:

▪ Which of these production functions have

diminishing marginal returns to labor?

CHAPTER 3 National Income slide 23

 Exercise (part 2) L Y MPL
0 0 n.a.
Suppose W/P = 6. 1 10 10
2 19 9
d. If L = 3, should firm hire more
3 27 8
or less labor? Why?
4 34 7
e. If L = 7, should firm hire more 5 40 6
or less labor? Why?
6 45 5
7 49 4
8 52 3
9 54 2
10 55 1

CHAPTER 3 National Income slide 24

 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 25

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

equilibrium
real wage MPL,
Labor
demand
Units of labor, L

CHAPTER 3 National Income slide 26

 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 27

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

equilibrium
R/P MPK,
demand for
capital
Units of capital, K

CHAPTER 3 National Income slide 28

 The Neoclassical Theory
of Distribution
▪ states that each factor input is paid its marginal
product
▪ is accepted by most economists

CHAPTER 3 National Income slide 29

 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 30

 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 31

 The Cobb-Douglas Production
Function
▪ The Cobb-Douglas production function has
constant factor shares:
α = capital’s share of total income:
capital income = MPK x K = α Y
labor income = MPL x L = (1 – α )Y
▪ The Cobb-Douglas production function is:

where A represents the level of technology.

CHAPTER 3 National Income slide 32
 The Cobb-Douglas Production
Function
▪ Each factor’s marginal product is proportional to
its average product:

CHAPTER 3 National Income slide 33

 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 slide 34

 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 35

 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 slide 36

 The consumption function
C

C (Y –T )

The slope of the

MPC
consumption function
1 is the MPC.

Y–T

CHAPTER 3 National Income slide 37

 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 38

 The investment function
r
Spending on
investment goods
depends negatively on
the real interest rate.

I (r )

CHAPTER 3 National Income slide 39

 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:

CHAPTER 3 National Income slide 40

 The market for goods & services

▪ Aggregate demand:

▪ Aggregate supply:

▪ Equilibrium:

▪ The real interest rate adjusts

to equate demand with supply.
CHAPTER 3 National Income slide 41
 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 42

 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 43

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

I (r )

CHAPTER 3 National Income slide 44

 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 45
 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 46

 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 47
 EXERCISE:
Calculate the change in saving

Suppose MPC = 0.8 and MPL = 20.

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

CHAPTER 3 National Income slide 48

 Answers

CHAPTER 3 National Income slide 49

 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.

CHAPTER 3 National Income slide 50

 U.S. Federal Government
Surplus/Deficit, 1940-2004

CHAPTER 3 National Income slide 51

 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 52

 Loanable funds supply curve
r

National saving
does not
depend on r,
so the supply
curve is vertical.

S, I

CHAPTER 3 National Income slide 53

 Loanable funds market
equilibrium
r

Equilibrium real
interest rate

I (r )
Equilibrium level S, I
of investment

CHAPTER 3 National Income slide 54

 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 Eq’m in goods
L.F. market market

CHAPTER 3 National Income slide 55

 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 56
 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 57
 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 58

 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 59
 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.

CHAPTER 3 National Income slide 60

 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 61

 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 62

 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 63
 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 64

 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)2
I(r)
I1 I2 S, I

CHAPTER 3 National Income slide 65

 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
CHAPTER 33 National
National Income
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
CHAPTER 33 National
National Income
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
CHAPTER 33 National
National Income
Income slide 68