Outline of model. The supply side The production function Y = F (K, L) A closed economy, market-clearing model

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1 CHAPTER THREE National Income: Where it Comes From and Where it Goes what what determines the the economy s total total output/income how how the the prices prices of of the the factors factors of of production are are determined how how total total income income is is distributed what what determines the the demand demand for for goods goods and and services services how how equilibrium in in the the goods goods market market is is achieved 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 The supply side The production function Y = F (K, L) K = capital L = labor F reflects the level of technology. exhibits constant returns to scale 1

2 Determining output If technology and input supply is fixed.. Output is determined by the fixed factor supplies and the fixed state of technology: Y = F ( K, L) Distribution of national income NOTATION NOTATION W W = nominal wage (price of L) = nominal wage (price of L) R R = nominal rental rate (price of K) = nominal rental rate (price of K) P P = price of output = price of output W /P W /P = real wage (measured in units of output) = real wage (measured in units of output) R /P R /P = real rental rate = real rental rate Income Income distribution distribution depends depends on on factor factor prices prices Supply Supply of of each each factor factor is is fixed. fixed. What What about about demand? demand? Demand for labor Assume markets are competitive: firm takes W, R, and P as given Firm solves: Max P F (K,L) W L R K Optimality condition : P MPL = W MPL: Extra output the firm can produce using an additional unit of labor (holding other inputs fixed): MPL = F (K, L +1) F (K, L) 2

3 The MPL and the production function Y output 1 MPL 1 F ( K, L) MPL 1 As more labor is MPL added, MPL (diminishing returns) Slope of the production function equals MPL L labor MPL and the demand for labor Units of output MPL, Labor demand Units of labor, L Determining the rental rate Capital demand? The MPK curve is the firm s demand curve for renting capital. Firms maximize profits by choosing K such that MPK = R/P. 3

4 How is income distributed? total labor income = W L P = MPL L total capital income = R K P = MPK K If production function has constant returns to scale: Y = MPL L + MPK K The demand side Demand for goods & services Aggregate demand = C + I + G Consumption def: disposable income = Y T Consumption function: C = C (Y T ) (Y T ) C 4

5 Investment The investment function is I = I (r ), r = real interest rate The real interest rate is the cost of borrowing the opportunity cost of using one s own funds to finance investment spending. 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 Equilibrium market for goods & services Agg. demand: CY ( T) + I( r) + G Agg. supply: Y = F ( K, L) Equilibrium: Y = CY ( T) + I( r) + G 5

6 THE LOANABLE FUNDS MARKET Different interpretation of the same model (different way of rewriting the same equations): 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 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 (the cost of borrowing). LD = L(r) Supply of funds: Saving The supply of loanable funds comes from saving: Households use saving to make bank deposits, purchase bonds and other assets. 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. 6

7 private saving Types of saving = (Y T ) C public saving = T G national saving, S = private saving + public saving = Y C G LS = L(Y,T,G) Public Saving: US Federal Govt Budget T-G G = budget surplus 4 0 % of GDP -4-8 (T -G ) as a % of GDP Loanable funds market equilibrium r S = Y C( Y T ) G Equilibrium real interest rate I (r ) Equilibrium level of investment S, I 7

8 The special role of r r adjusts to to equilibrate the goods market and the loanable funds market simultaneously: If If L.F. market in in equilibrium, then Y C G = I Add (C (C +G ) to to both sides to to get Y = C + I + G (goods market eq m) Thus, Eq m in L.F. market Eq m in goods market Mastering the loanable funds model 1. Factors shifting 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 2. Factors shifting the investment curve a. Technological innovations b. tax laws CASE STUDY The Reagan Deficits Reagan policies during early 1980s: increases in defense spending: ΔG > 0 big tax cuts: ΔT < 0 According to our model, both policies reduce national saving: S = Y C( Y T ) G G S T C S 8

9 The Reagan deficits,, cont. r S 2 S 1 r 2 r 1 I 2 I 1 I (r ) S, I Are the data consistent with these results? variable 1970s 1980s T G S rr II T G, S, and I are expressed as a percent of GDP All figures are averages over the decade shown. 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? 9

10 An increase in investment demand when saving depends on the interest rate Real interest rate, r S(r) raises the interest rate.. A B 1. An increase in desired investment... I and raises equilibrium investment and saving. I 1 Investment, Saving, I, S 10