Topic 3:

National Income:

macro Where it Comes From

and Where it Goes
(chapter 3)
macroeconomics
fifth edition

N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich

© 2002 Worth Publishers, all rights reserved

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.

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 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.

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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

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 Three Markets – Three agents
Labor Market hiring
work

Financial Market
saving borrowing borrowing

Households Government Firms

production
government
consumption spending investment

Goods Market

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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

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 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.

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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…

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 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

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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.

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 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

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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 )

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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.

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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.

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 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.

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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

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 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)

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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)

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 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 4 34 ?
with MPL on the 5 40 ?
vertical axis and 6 45 ?
L on the horizontal axis 7 49 ?
8 52 ?
9 54 ?
10 55 ?
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answers:

Production function Marginal Product of Labor

MPL (units of output)

12
Output (Y)

60
10
50
8
40
6
30
20 4

10 2

0 0
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Labor (L) Labor (L)

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

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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’

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 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

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Example: deriving labor demand

 Suppose a production function for all
firms in the economy:
Y  K 0.5L0.5
MPL  0.5K 0.5L0.5

Labor demand is where this equals real wage:

W
0.5K 0.5L0.5 
P

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

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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 )

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 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: 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.

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The consumption function

C

C (Y –T )

The slope of the

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

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 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

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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

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

I (r )

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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

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

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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.

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 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

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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.

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 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

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Algebra example
Suppose an economy characterized by:
 Factors market supply:
– labor supply= 1000
– Capital stock supply=1000

 Goods market supply:

– Production function: Y = 3K + 2L
 Goods market demand:
– Consumption function: C = 250 + 0.75(Y-T)
– Investment function: I = 1000 – 5000r
– G=1000, T = 1000

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 Algebra example continued
Given the exogenous variables (Y, G, T), find the
equilibrium values of the endogenous variables (r,
C, I)
Find r using the goods market equilibrium
condition:
Y=C+I+G
5000 = 250 + 0.75(5000-1000) +1000
-5000r + 1000
5000 = 5250 – 5000r
-250 = -5000r so r = 0.05

And I = 1000 – 5000*(0.05) = 750

C = 250 + 0.75(5000 - 1000) = 3250
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Algebra example continued

Suppose government spending rises by 250 to 1250
Use intuition first to make a conjecture.
Verify by algebra:
Y=C+I+G
5000 = 250 + 0.75(5000-1000) +1000–
5000r + 1250
-500 = -5000r, so r = 0.10
And I = 1000 – 5000*(0.10) = 500.
Investment falls by 250.

C = 250 + 0.75(5000 - 1000) = 3250 as

before for this consumption function.

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 Digression: mastering models
To learn a model well, 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 .

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Mastering the loanable funds model

1. 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
• replace income tax with
consumption tax

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 CASE STUDY
The Reagan Deficits
 Reagan policies during early 1980s:
 increases in defense
spending: DG > 0
 big tax cuts: DT < 0

 According to our model, both policies reduce

national saving:
S  Y  C (Y T )  G

G   S T   C   S

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1. The Reagan deficits, cont.

1. The increase in r S2 S1
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.

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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.

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Mastering the loanable funds model

2. Things that shift the investment curve
a. certain technological innovations
• to take advantage of the innovation,
firms must buy new investment goods
b. tax laws that affect investment
• investment tax credit

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An increase in investment demand
r S
An increase
…raises the in desired
interest rate. r2 investment…

r1
But the equilibrium
level of investment I2
cannot increase I1
because the
supply of loanable
S, I
funds is fixed.
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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).

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

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Chapter summary
6. 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.

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 TUGAS 1: P 77 No. 9 Edisi 7
Consider an economy described by the following equations:
 Y=C+I+G
 Y = 5,000
 G = 1,000
 T = 1,000
 C = 250 + 0.75(Y − T)
 I = 1,000 − 50 r.
a. In this economy, compute private saving, public saving, and national saving.
b. Find the equilibrium interest rate.
c. Now suppose that G rises to 1,250. Compute private saving, public saving,
and national saving.
d. Find the new equilibrium interest rate.

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TUGAS 2: KELOMPOK
 Bagaimana cara menghitung Produk
Domestik Bruto (PDB) atau Gross Domestic
Product (GDP) di Indonesia? Ada berapa
pendekatan?
 Berikan data PDB (untuk semua
pendekatan) di Indonesia untuk tahun
sesuai pada slide berikut.
 Untuk menjawab pertanyaan ini Anda bida
membuka website BPS – https://bps.go.id

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 Data per Kelompok
Kelompok Data PDB Harga Kelompok Data PDB Harga
Kontan Berlaku
1 Tahun 2010 dan 2011 6 Tahun 2010 dan 2011
2 Tahun 2012 dan 2013 7 Tahun 2012 dan 2013
3 Tahun 2014 dan 2015 8 Tahun 2014 dan 2015
4 Tahun 2016 dan 2017 9 Tahun 2016 dan 2017
5 Tahun 2018 dan 2019 10 Tahun 2018 dan 2019

CHAPTER 3 National Income slide 54

Ketentuan Pengiriman Jawaban

Untuk Tugas 1:
 Jawaban ditulis tangan
 Subject: T5_Ekonomika_10 Nov 2020
 Nama File: NIM_Nama_T5 Ekonomika_10 Nov 2020
 Dikirim ke [email protected]
Untuk Tugas 2:
 Subject: T6_Ekonomika_10 Nov 2020
 Nama File: Kel --_T6_Ekonomika_10 Nov 2020
 Dikirim ke [email protected]

CHAPTER 3 National Income slide 55

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