Mankiw: Macroeconomics. Fourth Edition. Chapter 3: National ...

Mankiw: Macroeconomics. Fourth Edition. Chapter 3: National Income: Where It Comes From and Where It Goes Page 1 I.

Introduction A. This chapter starts a section that looks at the economy in the long run. 1. We are interested in explaining: a. Interest rates: nominal and real, b. Income and output: nominal and real, c. Wages: nominal and real, d. Prices, e. Employment and unemployment, and f. Exchange rates. B. We are interested in four groups of questions about the sources and uses of GDP: 1. How much do the firms in the economy produce? What determines a nation's total income? 2. Who gets the income? Labor vs. Capital. 3. Who buys the output? C vs I vs G. 4. What makes the system go to equilibrium? C. Figure 3-1: The circular flow of dollars through the economy, p. 43.

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What Determines the Total Production of Goods and Services? A. An economy's output depends on 1. the quantities of the inputs and 2. its ability to turn inputs into outputs. B. The factors of production: The inputs used to produce goods and services. 1. Labor and capital are fixed. C. The production function: It shows how the factors of production determine the amount of output produced. 1. Y=F(K, L) 2. Constant returns to scale: It occurs when, for a production function, an increase of an equal percentage in all factors of production causes an increase in output of the same percentage. a. zY=F(zK, zL) D. The fixed supply of goods and services leads to a fixed output.

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Distributing National Income to the Factors of Production is based on factor prices. A. Factor prices: the amounts paid to the factors of production. B. Figure 3-2: How a factor of production is compensated, p. 47. C. The problem facing the competitive firm. 1. Competitive firm: A firm that is small relative to the size of the markets in which trades. 2. It sells its output at P, hires workers at W and rents capital at R. a. Capital is rented from its owners. 3. Profit=Revenue-labor costs-capital costs=PY-WL-RK

Mankiw: Macroeconomics. Fourth Edition. Chapter 3: National Income: Where It Comes From and Where It Goes Page 2 D.

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The firm's demand for factors. 1. The marginal product of labor (MPL): The extra amount of output the firm gets from one extra unit of labor. a. MPL=F(K,L+1)-F(K,L) b. Diminishing marginal product: Holding the amount of capital fixed, the marginal product of labor decreases as the amount of labor increases. c. Figure 3-3: The production function, p. 49. (1) It demonstrates diminishing returns. 2. From the marginal product of labor to labor demand. a. Real wage: The return to labor measured in units of output rather than in dollars. the amount of purchasing power that the firm pays for each unit of labor. (1) Real wage=W/P. b. The firms demand for labor is P x MPL = W. c. This can be rewritten as MPL = W/P. 3. The marginal product of capital and capital demand. a. Marginal product of capital (MPK): The amount of extra output the firm gets from an extra unit of capital. (1) MPK=F(K+1,L)-F(K,L). b. Figure 3-4: The marginal product of labor schedule, p. 51. c. The real rental price of capital: The rental price measured in units of goods rather than in dollars. (1) MPK=R/P d. The firm demands each factor of production until that factor's marginal product falls to equal its real factor price, so that MPK = R/P. 4. The firm demands each factor of production until that factor's marginal product falls to equal its real factor price. The division of national income: 1. Economic profit: The income that remains after the firm have paid the factors of production. E. Profit= Y-(MPLxL)-(MPKxK) a. Euler's Theorem: If the production function has constant returns to scale, then: F(K,L)= (MPKxK)+ (MPLxL) b. Economic profits are zero. 2. Accounting profit = Economic Profit + (MPK x K) 3. Total output is divided between the payments to capital and the payments to labor, depending on their marginal productivities. a. The underlying assumptions are: (1) constant returns to scale, (2) profit maximization, and

Mankiw: Macroeconomics. Fourth Edition. Chapter 3: National Income: Where It Comes From and Where It Goes Page 3 F.

(3) competition. Case-study: The black death and factors prices, p. 55. 1. It was good for the survivors.

IV.

What Determines the Demand for Goods and Services? A. National income accounts identity: Y=C+I+G B. Consumption depends on disposable income. 1. Disposable income: Income after the payment of all taxes. 2. Consumption function: The relationship between consumption and disposable income. a. C=C(Y-T) 3. Marginal propensity to consume (MPC): The amount consumption changes when disposable income increases by one dollar. 4. Figure 3-5: The consumption function, p. 55. C. Investment depends on the real interest rate. 1. Nominal interest rate: The rate that investors pay to borrow money. 2. Real interest rate: The nominal interest rate corrected for the effects of inflation. 3. I = I(r). 4. Figure 3-6: The investment function, p. 56. 5. FYI: The Many Different Interest Rates, p. 57. D. Government purchases. 1. Transfer payments are part of disposable income. 2. Both taxes and government purchases are given.

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Equilibrium and the Interest Rate: A. Equilibrium in the market for goods and services: The supply and demand for the economy's output. 1. Y=C+I+G 2. C = C(Y-T) 3. I = I(r) 4. G is given. 5. T is given. 6. Y = F(K,L) and it is given. 7. Therefore, a. Y = C(Y-T) + I(r) + G 8. At the equilibrium interest rate, the demand for goods and services equals the supply. B. Equilibrium in the financial markets: the supply and demand for loanable funds. 1. T-C-G=I 2. Savings consists of private saving (Y-T-C) and public saving (T-G) with

Mankiw: Macroeconomics. Fourth Edition. Chapter 3: National Income: Where It Comes From and Where It Goes Page 4 national saving being their sum. Y- C(Y-T) - G= I(r) S(given) = I(r) Figure 3-7: Saving, investment, and the interest rate, p. 61. Loanable funds: The "good" when saving and investment are interpreted in terms of supply and demand. 7. At the equilibrium interest rate, savings equals investment, and the supply of loans equals the demand. Changes in saving: The effects of fiscal policy. 1. An increase in government purchases. a. Crowd out: It appears when increase in government purchases causes the interest rate to increase and the investment to decrease. b. The government purchases cause a deficit and thereby reduce national savings. c. With less savings the financial markets clear at a higher rate of interest. 2. Figure 3-8: A reduction in saving, p. 62. 3. Case-study: Wars and interest rates in the U.K., 1730-1920, p. 63. a. Figure 3.9: Military spending and the interest rate in the U.K., p. 63. 4. A decrease in taxes. a. T8 6 C8 I9 because r8. b. Another example of crowding out. 5. Case-study: Fiscal policy in the 1980's, p. 64. a. As predicted by the model, r rose and S fell. Changes in investment demand: 1. Due to new technology or lower taxes. 2. However, it increases the quantity of it can not increase if savings is fixed. a. The only effect will be an increase in the rate of interest. b. Figure 3-10: An increase in the demand for investment, p. 65. 3. If savings is a function of the interest rate, an increase in I can result in an increase in the quantity of investment. a. Figure 3-11: Saving as a function of the interest rate, p. 66. b. Figure 3-12: An increase in investment demand when saving depends on the interest rate, p. 66. 4. FYI: The identification problem, p. 68. a. Figure 3-13: Identifying the investment function, p. 68. 3. 4. 5. 6.

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VI.

Conclusion.

VII.

Summary.

Mankiw: Macroeconomics. Fourth Edition. Chapter 3: National Income: Where It Comes From and Where It Goes Page 5 VIII.

Appendix: The Cobb-Douglas Production Function A. You are not expected to know this material. B. Fig. 3.14 The Ratio of Labor Income to Total Income, p. 75.