Download Mankiw 6e PowerPoints

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
CHAPTER 3
National Income
slide 0
Factors of production
K = capital:
tools, machines, and structures used in
production
L = labor:
the physical and mental efforts of
workers
CHAPTER 3
National Income
slide 1
The production function
 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
 exhibits constant returns to scale
CHAPTER 3
National Income
slide 2
Returns to scale: A review
Initially Y1 = F (K1 , L1 )
Scale all inputs by the same factor z:
K2 = zK1 and L2 = zL1
(e.g., 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
CHAPTER 3
National Income
slide 3
Example 2
F (K , L) 
K L
F (zK , zL) 

z K z L

z

CHAPTER 3
zK  zL

K L
z F (K , L)
National Income

decreasing
returns to scale
for any z > 1
slide 4
CHAPTER 3
National Income
slide 5
Assumptions of the model
1. Technology is fixed.
2. The economy’s supplies of capital and labor
are fixed at
K K
CHAPTER 3
and
National Income
LL
slide 6
Determining GDP
Output is determined by the fixed factor supplies
and the fixed state of technology:
Y  F (K , L)
CHAPTER 3
National Income
slide 7
The distribution of national
income
 determined by factor prices,
the prices per unit that firms pay for the
factors of production
 wage = price of L
 rental rate = price of K
CHAPTER 3
National Income
slide 8
Notation
W
= nominal wage
R
= nominal rental rate
P
= price of output
W /P = real wage
(measured in units of output)
R /P = real rental rate
CHAPTER 3
National Income
slide 9
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?
CHAPTER 3
National Income
slide 10
Demand for labor
 Assume markets are competitive:
each firm takes W, R, and P as given.
 Basic idea:
A firm hires each unit of labor
if the cost does not exceed the benefit.
 cost = real wage
 benefit = marginal product of labor
CHAPTER 3
National Income
slide 11
Marginal product of labor (MPL )
 definition:
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)
CHAPTER 3
National Income
slide 12
Exercise: Compute & graph MPL
a. Determine MPL at each
value of L.
b. Graph the production
function.
c. Graph the MPL curve with
MPL on the vertical axis
and
L on the horizontal axis.
CHAPTER 3
National Income
L
0
1
2
3
4
5
6
7
8
9
10
Y
0
10
19
27
34
40
45
49
52
54
55
MPL
n.a.
?
?
8
?
?
?
?
?
?
?
slide 13
Answers:
Marginal Product of Labor
MPL (units of output)
Output (Y)
Production function
60
50
40
30
20
10
12
10
8
6
4
2
0
0
0
1
2
3
4
5
6
7
8
9 10
Labor (L)
CHAPTER 3
National Income
0
1
2
3
4
5
6
7
8
9 10
Labor (L)
slide 14
MPL and the production function
Y
output
F (K , L )
1
MPL
MPL
As more labor is
added, MPL 
1
MPL
Slope of the production
function equals MPL
1
L
labor
CHAPTER 3
National Income
slide 15
Diminishing marginal returns
 As a factor input is increased,
its marginal product falls (other things equal).
 Intuition:
Suppose L while holding K fixed
 fewer machines per worker
 lower worker productivity
CHAPTER 3
National Income
slide 16
MPL and the demand for labor
Units of
output
Each firm hires labor
up to the point where
MPL = W/P.
Real
wage
MPL,
Labor
demand
Units of labor, L
Quantity of labor
demanded
CHAPTER 3
National Income
slide 17
The equilibrium real wage
Units of
output
Labor
supply
equilibrium
real wage
L
CHAPTER 3
National Income
The real wage
adjusts to equate
labor demand
with supply.
MPL,
Labor
demand
Units of labor, L
slide 18
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 .
CHAPTER 3
National Income
slide 19
The equilibrium real rental rate
Units of
output
Supply of
capital
equilibrium
R/P
K
CHAPTER 3
National Income
The real rental rate
adjusts to equate
demand for capital
with supply.
MPK,
demand for
capital
Units of capital, K
slide 20
The Neoclassical Theory
of Distribution
 states that each factor input is paid its marginal
product
 is accepted by most economists
CHAPTER 3
National Income
slide 21
How income is distributed:
W
L  MPL  L
total labor income =
P
R
K  MPK  K
total capital income =
P
If production function has constant returns to
scale, then
Y  MPL  L  MPK  K
national
income
CHAPTER 3
labor
income
National Income
capital
income
slide 22
The ratio of labor income to total
income in Canada.
1
Labor’s
share
of total 0.8
income
0.6
Labor’s share of income
is approximately constant over time.
(Hence, capital’s share is, too.)
0.4
0.2
0
1960
CHAPTER 3
1970
National Income
1980
1990
2000
slide 23
The Cobb-Douglas Production
Function
 The Cobb-Douglas production function has
constant factor shares:
 = capital’s share of total income:
capital income = MPK x K =  Y
labor income = MPL x L = (1 –  )Y
 The Cobb-Douglas production function is:
Y  AK  L1
where A represents the level of technology.
CHAPTER 3
National Income
slide 24
The Cobb-Douglas Production
Function
 Each factor’s marginal product is proportional to
its average product:
MPK   AK
 1 1
L

Y
K
(1   )Y
 
MPL  (1   ) AK L 
L
CHAPTER 3
National Income
slide 25
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 )
CHAPTER 3
National Income
slide 26
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: Marginal propensity to consume (MPC)
is the increase in C caused by a one-unit
increase in disposable income.
CHAPTER 3
National Income
slide 27
The consumption function
C
C (Y –T )
MPC
1
The slope of the
consumption function
is the MPC.
Y–T
CHAPTER 3
National Income
slide 28
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
CHAPTER 3
National Income
slide 29
The investment function
r
Spending on
investment goods
depends negatively on
the real interest rate.
I (r )
I
CHAPTER 3
National Income
slide 30
Government spending, G
 G = govt spending on goods and services.
 G excludes transfer payments
(e.g., social security benefits,
unemployment insurance benefits).
 Assume government spending and total taxes
are exogenous:
G G
CHAPTER 3
National Income
and
T T
slide 31
The market for goods & services
 Aggregate demand:
C (Y  T )  I (r )  G
 Aggregate supply:
 Equilibrium:
Y  F (K , L )
Y = C (Y  T )  I (r )  G
 The real interest rate adjusts
to equate demand with supply.
CHAPTER 3
National Income
slide 32
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
CHAPTER 3
National Income
slide 33
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
(cost of borrowing).
CHAPTER 3
National Income
slide 34
Loanable funds demand curve
r
The investment
curve is also the
demand curve for
loanable funds.
I (r )
I
CHAPTER 3
National Income
slide 35
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 the tax revenue it
receives.
CHAPTER 3
National Income
slide 36
Types of saving
private saving = (Y – T ) – C
public saving
=
T – G
national saving, S
= private saving + public saving
= (Y –T ) – C +
=
CHAPTER 3
T–G
Y – C – G
National Income
slide 37
Budget surpluses and deficits
 If T > G, budget surplus = (T – G)
= public saving.
 If T < G, budget deficit = (G – T)
and public saving is negative.
 If T = G, “balanced budget,” public saving = 0.
 The Cdn government finances its deficit by
issuing bonds – i.e., borrowing.
CHAPTER 3
National Income
slide 38
Loanable funds supply curve
r
S  Y  C (Y  T )  G
National saving
does not
depend on r,
so the supply
curve is vertical.
S, I
CHAPTER 3
National Income
slide 39
Loanable funds market
equilibrium
r
S  Y  C (Y  T )  G
Equilibrium real
interest rate
I (r )
Equilibrium level
of investment
CHAPTER 3
National Income
S, I
slide 40
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,
CHAPTER 3
Eq’m in L.F.
market
National Income

Eq’m in goods
market
slide 41
Digression: Mastering models
To master a model, 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.
CHAPTER 3
National Income
slide 42
Mastering the loanable funds
model
Things that shift the saving curve
 public saving
 fiscal policy: changes in G or T
 private saving
 preferences
 tax laws that affect saving
– RRSP
– Revenue Canada
– replace income tax with consumption tax
CHAPTER 3
National Income
slide 43
Mastering the loanable funds
model, continued
Things that shift the investment curve
 some technological innovations
 to take advantage of the innovation,
firms must buy new investment goods
 tax laws that affect investment
 investment tax credit
CHAPTER 3
National Income
slide 44
An increase in investment demand
r
…raises the
interest rate.
r2
S
An increase
in desired
investment…
r1
But the equilibrium
level of investment
cannot increase
because the
supply of loanable
funds is fixed.
CHAPTER 3
National Income
I1
I2
S, I
slide 45
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?
CHAPTER 3
National Income
slide 46
An increase in investment demand
when saving depends on r
An increase in
investment demand
raises r,
which induces an
increase in the
quantity of saving,
which allows I
to increase.
r
S (r )
r2
r1
I(r)2
I(r)
I1 I2
CHAPTER 3
National Income
S, I
slide 47