1. Instructor Sandeep Basnyat Sandeep_basnyat@yahoo.com 9841 892281
Macroeconomics & The Global Economy Term III Ace Institute of Management Chapter 3: National income-where it comes and where it goes?
Instructor
Sandeep Basnyat

2. What Macroeconomics study?
Some of the foremost important questions that macroeconomics tries to investigate are:
What determines the total income in an economy?
What determines the level of production in an economy?
Who gets the income from production?
How the income is distributed among the factors of production?
In general,
How the economy works?
Simple demonstration: Circular Flow of Income Model

3. Equilibrium Level of National Income
Foreign Sector
International Capital Flows
Exports (X)
Imports (M)
National Products
Market for goods
and Services
Consumption Expenditure (C)
Government Purchase (G)
Transfer Payments
Government
Investment (I)
Taxes (T)
Firms
Households
Loans
Repay
Loans or
Investment Funds
Savings (S)
Financial
Services
National
Income (Y)
Market for Factors
of Production
Wages, Interest, Rent and Profit
S + T + M = I + G + X Total Leakages = Total Injections
Aggregate Demand (AD) = Aggregate Supply (AS)

4. How do the interactions occur in an economy
How do the interactions occur in an economy? Our first theory: the Neo classical theory (based on classical theory)

5. Welcome to... The Classical Factory The place where Classical-model
mechanics
are made easy! P Q P* Q* S D

6. What is the Classical Model?
Its roots go back to 1776—to Adam Smith’s Wealth of Nations.
Economy was controlled by the “invisible hand”
Market system, instead of government mechanism
Buyers and sellers pursuing their own self-interest
Emphasis on competition and flexible wages/prices
Prices adjust to balance supply and demand in an economy
Economy usually maintains Full employment of resources and general equilibrium in economy

7. How will we proceed? Sequence of Questions and Answers:
What determines the level of output (or National Income) in an economy?
What determines the distribution of national income among factors of production?
What determines the factor prices?
What determines the demand for factor of production?

8. What determines the Total Production of Goods and Services?
An economy’s output of goods and services (GDP) depends on:
Quantity of inputs : Factors of Production (Capital and Labour)
Ability to turn inputs into output : Production Function

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

10. The production function
Usually 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.
Assumption: exhibits constant returns to scale
(Meaning: If we increase inputs by z, output will also increase by z.)

11. Returns to scale: a review
Initially Y1 = F (K1 , L1 )
Scale all inputs by the same factor z:
K2 = zK1 and L2 = zL1
(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
Note for students: If a 25% increase in both capital and labour causes output to increase by more than 25%, then the production function is said to exhibit increasing returns to scale. if it causes output to increase by less than 25%, then the production function is said to exhibit decreasing returns to scale and if it causes output to increase exactly by the equal amount, then the production function is said to exhibit constant returns to scale.

12. Other assumptions of the model
Technology is fixed.
The economy’s supplies of capital and labor are fixed at

13. Determining Output: GDP
Factors of Production and Production Function together determine the Total Output in the Economy.
Since Technology (production function) and K and L are assumed to be fixed, the output (Y) is also assumed to be fixed in an economy.
Y = Y

14. How will we proceed? Sequence of Questions and Answers:
What determines the level of output (or National Income) in an economy?
Factors of Production and the Production function
What determines the distribution of national income among factors of production?
What determines the demand for factors of production?

15. The distribution of national income
Determined by factor prices: the prices per unit that firms pay for the factors of production.
The wage is the price of L ,
the rental rate is the price of K.

16. Notation W = nominal wage R = nominal rental rate P = price of output
W /P = real wage (measured in units of output)
[Note: P = i (inflation) reflects price level and Real Wage rate in %]
R /P = real rental rate

17. 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?

18. Determination of Factor Prices
Factor prices are determined by supply and demand in factor markets.
Factor
price
(Wage or
rental
rate)
Quantity of factor
Factor demand
Factor supply
Equilibrium
factor price
This vertical supply curve
is a result of the
supply being fixed.
What about demand?

19. What determines the demand for factors of production?
Factor Prices
Because the factor supply curve is vertical and fixed, it is the demand curve for the factors of productions which determines the distribution of income among them.
Big Question:
What determines the demand for factors of production?

20. The Firm's Demand for Factors
We know that the firm will hire labor and rent capital in the quantities that maximize profit.
But what are those maximizing quantities?
Answer: Depends upon Marginal Revenue earned from Marginal Product of Labour and Marginal Product of Capital.

21. Marginal product of labor (MPL)
Def: 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)

22. The MPL and the production functionY
output 1
MPL
As more labor is added, MPL  1
MPL
To the instructor:
It’s straightforward to see that the MPL = the prod function’s slope: The definition of the slope of a curve is the amount the curve rises when you move one unit to the right. On this graph, moving one unit to the right simply means using one additional unit of labor. The amount the curve rises is the amount by which output increases: the MPL.
Slope of the production function equals MPL
MPL 1 L
labor

23. Diminishing marginal returns
As a factor input is increased, its marginal product falls (other things equal).
Intuition: L while holding K fixed
 fewer machines per worker
 lower productivity

24. MPL and the demand for labor
Units of output
Units of labor, L
Each firm hires labor up to the point where
P × MPL (VMPL) = W
MPL = W/P
MPL, Labor demand
Real wage
Quantity of labor demanded

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

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 .

27. The equilibrium real rental rate
Units of output
Units of capital, K
Supply of capital
The real rental rate adjusts to equate demand for capital with supply.
MPK, demand for capital
equilibrium R/P

28. How income is distributed:
total labor income =
total capital income =
If production function has constant returns to scale, then
national income
labor income
capital income

29. The Division of National Income
The income that remains after firms have paid the factors of production is the economic profit of the firms’ owners.
Real economic profit is:
Economic Profit = Y - (MPL × L) - (MPK × K)
or to rearrange: Y = (MPL × L) + (MPK × K) + Economic Profit.
Usually we find (Lumping Y and MPL into Eco. Profit):
Accounting Profit = Economic Profit + (MPK x K)

30. The Cobb-Douglas Production Function
Paul Douglas observed that the division of
national income between capital and labor has been
roughly constant over time.
In other words, the total income of workers and the total income of capital owners grew at almost exactly the
same rate.
He then wondered what conditions might lead to constant factor shares. Cobb, a mathematician, said that the production function would need to have the property that:
Paul Douglas
Capital Income = MPK × K = αY
Labor Income = MPL × L = (1- α) Y

31. Cobb–Douglas Production Function
Capital Income = MPK × K = α Y
Labor Income = MPL × L = (1- α) Y
α is a constant and measures capital and
labors’ share of income.
Production Function
Cobb-Douglas
Cobb showed that the function with this property is:
F (K, L) = A Kα L1- α
A is a parameter that measures the productivity
of the available technology. (Total Factor Productivity)

32. Cobb–Douglas Production Function
Y = F (K, L) = A Kα L1- α
Differentiating, we get the Marginal product of labor:
MPL = (1- α) A Kα L–α
Multiply and Divide right hand side by L. Then,
MPL = (1- α) [A Kα L–α ] L / L = (1- α) [A Kα L1-α ] / L
MPL = (1- α) Y / L
Similarly, The Marginal product of capital is:
MPK = α A Kα-1L1–α or, MPK = α Y/K
Average Labour Productivity
Average Capital Productivity

33. Properties of the Cobb–Douglas Production Function
(1) Consider the Cobb–Douglas production function:
MPL = (1- α)Y/L ………….(i)
MPK= α Y/ K ………………(ii)
Equation (i) tells us that marginal product of the labour is proportional to output per worker (average productivity of worker).
Similarly, equation (ii) states that marginal product of the capital is proportional to the output per unit of capital (average productivity of capital).
In conclusion,
Marginal productivity of a factor is proportional to its average productivity.

34. Properties of the Cobb–Douglas Production Function
2) The Cobb–Douglas production function has constant returns to scale. That is, if capital and labor are increased by the same proportion, then output increases by the same proportion as well.
Proof:
Consider the Cobb-Douglas Production function:
F (K, L) = A Kα L1- α
F(zK,zL) = A(zK)α (zL)1- α
F(zK,zL) = Az α Kαz1- αL1- α
F(zK,zL) = Az α z1- α KαL1- α
F(zK,zL) = Az α+1- α KαL1- α
F(zK,zL) = Az KαL1- α = zA KαL1- α = zF(K,L) = zY
Therefore, Cobb-Douglas production function has constant returns to scale.

35. Growth in Labour productivity and Real Wages in US
Empirical Evidence of the Cobb–Douglas Production Function
According to C.D. Prod. Func. : MPL α Y/L
According to Neo Classical Theory, MPL = W /P
So, MPL α W/P
Growth in Labour productivity and Real Wages in US
Period Labour Productivity Real Wages
Growth rate Growth rate
% %
% %
% %
% %
Source: US Economic Report of the President, 2005.
FYI: Prepare list of some of countries that support Cobb-Douglas production function with their growth rates.

36. How will we proceed? Sequence of Questions and Answers:
What determines the level of output (or National Income) in an economy?
Factors of Production and the Production function
What determines the distribution of national income among factors of production?
Factor Prices
What determines the demand for factors of production?

37. 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 )

38. 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 is the increase in C caused by a one-unit increase in disposable income.
MPC = (YT ) / C = (Y  T ) / C
Or, C = MPC  (Y  T )

39. The consumption function
Y – T
C (Y –T )
The slope of the consumption function is the MPC.
MPC 1

40. 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

41. The investment functionr I
Spending on investment goods is a downward-sloping function of the real interest rate
I (r )

42. Government spending, G
G includes government spending on goods and services.
G excludes transfer payments
Assume government spending and total taxes are exogenous:

43. 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.

44. Equilibrium in The market for goods & services
The real interest rate adjusts to equate demand with supply.

45. Equilibrium in the Financial Market: 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

46. 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).

47. Loanable funds demand curveI
The investment curve is also the demand curve for loanable funds.
I (r )

48. 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.

49. 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

50. Loanable funds supply curve
S, I
National saving does not depend on r, so the supply curve is vertical.

51. Loanable funds market equilibrium
S, I
I (r )
Equilibrium real interest rate
Equilibrium level of investment

52. 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
S = 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

53. Fiscal Policy Operations: Increase/Decrease in “G” or ‘T”
Changes in Saving: The Effects of Fiscal Policy
Fiscal Policy Operations: Increase/Decrease in “G” or ‘T”
An Increase in Government Purchases (G) by DG :
Total demand for goods and services
General price level and demand for money
(Since Total Output ( Supply) is fixed)
Savings
Interest rate
Investment level
Thus, government purchases are said to crowd out investment

54. The Crowd-out effect r r2 r1 I (r ) S, I
1. The increase in the deficit reduces saving… r
S, I
I (r ) r2
2. …which causes the real interest rate to rise… r1
3. …which reduces the level of investment. I2 I1

55. Fiscal Policy Operations: Increase/Decrease in “G” or ‘T”
Changes in Saving: The Effects of Fiscal Policy
Fiscal Policy Operations: Increase/Decrease in “G” or ‘T”
A Decrease in Taxes:
Disposable (Y-T) income
Consumption (C)
Saving decreases
(Since Y is fixed and C increased: Note: S =Y-C-G)
Interest rate (r)
Like an increase in government purchases, tax cuts crowd out investment and raise the interest rate.

56. Changes in Investment Demand Changes in Investment Demand
Two reasons: Technological changes and Tax Policy
Investment, Saving, I, S I1
Real
interest
rate, r
Saving, S S I2 A B
An increase in the demand for
investment goods shifts the investment
schedule to the right. At any given
interest rate, the amount of investment
is greater. The equilibrium moves
from A to B. Because the amount
of saving is fixed, the increase in
investment demand raises
the interest rate while leaving
the equilibrium
amount of investment
unchanged.
But, what if interest rates are even higher?

57. upward-sloping S(r) curve.
Investment, Saving, I, S I1
Real
interest
rate, r
S(r) I2 A B
Upward sloping savings
The higher interest rate induces people to decrease consumption and increase saving, which in turn allows investment to increase.
When saving is positively related to the interest rate, it results in the
upward-sloping S(r) curve.
A rightward shift in the investment schedule I(r)
increases the interest rate (r) and the amount of investment (I).

58. Numerical Questions and Solutions for Practice
3) An economy's production function is cobb-douglas with parameter α =0.3. (Macroeconomics, mankiw, Pg. 73. Q. 3)
a. what fractions of income do capital and labor recieve? b. suppose that immigration increases the labor force by 10 percent. what happens to total output (in percent)? c. Suppose that a technological advance raises the value of the parameter A by 10 percent. what happens to total output (in percent)?

59. What fractions of income do capital and labor receive?
Solutions for Practice
3) An economy's production function is cobb-douglas with parameter α =0.3. (Macroeconomics, mankiw, Pg. 73. Q. 3)
What fractions of income do capital and labor receive?
0.3 is a fraction of labor income while 0.7 is a fraction of capital income

60. Numerical Questions and Solutions for Practice
3) An economy's production function is cobb-douglas with parameter α =0.3. (Macroeconomics, mankiw, Pg. 73. Q. 3)
b. Suppose that immigration increases the labor force by 10 percent. what happens to total output (in percent)?
Out put will increase 10%.

61. Numerical Questions and Solutions for Practice
3) An economy's production function is cobb-douglas with parameter α =0.3. (Macroeconomics, mankiw, Pg. 73. Q. 3)
c. suppose that a technological advance raises the value of the parameter A by 10 percent. what happens to total output (in percent)?
Output increases by 10%

62. Thank You