Chapter-3: National Income: Where It Comes From and Where It Goes
Chapter-3: National Income: Where It Comes From and Where It Goes
Chapter-3: National Income: Where It Comes From and Where It Goes
COURSE TEACHER:
D R . TA M G I D A H M E D C H O W D H U R Y
A S S I S TA N T P R O F E S S O R , S B E
OBJECTIVES OF THE CHAPTER
Question: In the
Diagram, among
A, B, C, and D,
which transaction is
beneficial for the
country?
TOTAL PRODUCTION OF GOODS AND SERVICES: SUPPLY
SIDE ANALYSIS
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
• Generally, we will assume it exhibits constant returns to scale. This means change
in output is proportional to change in input. Mathematically:
zY = F (zK, zL)
• However, the production process may also exhibit increasing and decreasing returns
to scale. For example:
- Labor and capital have been doubled but output is more than doubled (increasing
scale): 3Y = F (2K, 2L)
- Labor and capital have been doubled but output is less than doubled (decreasing
scale): 1.5Y = F (2K, 2L)
DETERMINING GDP/NATIONAL INCOME
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 )
GOODS AND SERVICE MARKET: DEMAND SIDE
ANALYSIS
Components of aggregate demand: Y = C + I + G
C = consumer demand for g & s
I = demand for investment goods
G = government demand for g & s
(closed economy: no NX )
For open economy:
Y = C + I + G + NX
CONSUMPTION (C)
• def: disposable income is total income minus total taxes: Y–T
• Consumption function: The relation between consumption and disposable
income.
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. Mathematically: MPC = dC/dY. This equation justifies that MPC is
the slope of the consumption curve.
• MPC must be between 0 and 1. MPC = 0.70 means that households spend 70%
of their income on consumption.
CONSUMPTION FUNCTION
Y–T
CONSUMPTION AND DISPOSABLE INCOME:
BANGLADESH CASE
INVESTMENT (I)
• the action or process of investing money (or even time) for profit.
• 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
INVESTMENT CURVE
The demand for loanable
funds:
• comes from investment:
r
Spending on investment Firms borrow to finance
goods spending on plant &
is a downward-sloping equipment, new office
function of the real buildings, etc. Consumers
interest rate borrow to buy new houses.
• depends negatively on r ,
the “price” of loanable
funds (the cost of
borrowing).
I (r )
I
TREND OF INVESTMENT IN BANGLADESH
Chart Title
35
30
2012-13 2013-14 2014-15
25
Growth of Private Inv 9.81 13.54 12.84
20
Growth of Public Inv 30.92 10.43 18.77
15
Growth of total Inv 14.12 12.81 14.2
10
Inv as % of GDP 28.38 28.57 28.97
5
0
2012-13 2013-14 2014-15
Growth of Private Inv Growth of Public Inv Growth of total Inv Inv as % of GDP
GOVERNMENT PURCHASES
• 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
• 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.
GOVERNMENT SPENDING, BUDGET DEFICIT, AND DEBT:
BANGLADESH CASE
EQUILIBRIUM IN GOODS AND SERVICE MARKET
Agg. demand: C (Y T ) I (r ) G
Agg. supply: Y F (K , L )
Equilibrium: Y = C (Y T ) I (r ) G
The
Thereal
realinterest
interestrate
rateadjusts
adjusts
to
toequate
equatedemand
demandwith
withsupply.
supply.
EQUILIBRIUM IN THE FACTORS MARKET
• Equilibrium is where factor supply equals Factor supply
factor demand.
Factor
• Factor prices are the amounts paid to the price
factors of production and this is determined by
factor demand and factor supply.
Equilibrium
• Supply of factors is fixed (thus a perfectly
factor price
vertical supply curve).
• Demand for factors comes from firms. Higher
factor price will lower the demand for factors
Factor demand
as firms have fixed investment capital. This
makes the factor demand curve downward
slopping.
Quantity of factor
FIRM’S DEMAND FOR FACTOR: HOW THEY DECIDE
9
1
Y 1 1
fL 3 L 2 6
L 2
1 3
3 2 3
L
2 2 L
1 4 9 L
L: 1 4 9
F(L): 3 6 9
fL: 1.5 0.75 0.5
RETURN TO THE FIRM’S PROBLEM: CHOOSING
THE RIGHT AMOUNT OF LABOUR
Firm chooses L to maximize its profit.
How will increasing L change profit?
D profit = D revenue - D cost = D (P * Q) - D cost
= P * MPL - W (note: here Q is the extra output produced by extra labor thus MPL)
If this is:> 0 should hire more
< 0 should hire less
= 0 hiring right amount
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’
Mathematical note: Assume bread price is 2 Taka and a worker earns 20 Taka/hour. Real wage is
20/2 = 10 breads/hour. This bakery should continue hiring as long as additional worker can
produce 10 breads/hour.
DEMAND FOR LABOR ESTIMATION
labor supply
Units of
output Each
Eachfirm
firmhires
hireslabor
labor
up
upto
tothe
thepoint
pointwhere
where
MPL
MPL==W/P W/P
Real
wage
MPL, Labor
demand
L Units of labor, L
CHOOSING THE RIGHT AMOUNT OF CAPITAL
D profit = D revenue - D cost= D (P * Q) - D cost
= P * MPK - R (note: here Q is the extra output produced by extra Capital thus
MPK)
If this is: > 0 should use more
< 0 should use less
= 0 right amount of capital
So the firm’s demand for labor is determined by the condition:
P *MPK = R
Hires more and more K, until MPK falls enough to satisfy the condition.
Also may be written:
MPK = R/P, where R/P is the ‘real rental price of capital’
Firm’s decision criterion: The firm’ demands each factor of production until that factor’s
marginal product falls to equal to its real factor price (such as, real wage or real rental
price).
SUPPLY OF LOANABLE FUNDS: SAVINGS
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.
• private saving (sp) = (Y –T ) – C
• national saving, S
= sp + sg
= (Y –T ) – C + T – G
= Y – C – G = I (r) (Note: Y = C + I + G)
= S = I(r)
TREND OF SAVINGS IN BANGLADESH
SAVINGS, INVESTMENT AND THE INTEREST RATE
r S Y C (Y T ) G
National saving
does not
depend on r,
Equilibrium real
so the supply
interest rate
curve is
vertical.
I (r )
Equilibrium level S, I
of investment
CHANGE IN SAVINGS AND EFFECTS IN THE MARKET
1. The increase in r S1
S2
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.
MATHEMATICAL EXAMPLE OF NATIONAL
INCOME ACCOUNTING
Suppose an economy characterized by:
• Factors market supply:
– labor supply= 1000 Find the equilibrium
values of the endogenous
– Capital stock supply=1000 variables (r, C, I)
• 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
SOLUTION TO THE PROBLEM
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