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Lecture 2: National Income: Where It Comes

From and Where It Goes


February 3, 2009
We begin with firms and how they determine output levels, and therefore
national income collectively. Then we look at how the markets for the dierent
production factors distribute the national income to households. Then we look
at how this income is divided between consumption demand and savings on
the consumer side, and we also look at investment demand and government
purchases. Then finally we close the model by putting together the demand and
the supply sides of the goods market:
C +I +G=Y
(consumption+investment+government purchases equal total production).

The aggregate production function

Y = F (K, L),
where K is aggregate capital stock and L is aggregate labor supply.

Factors of production: K and L


Production function: F
Aggregate output: Y
We assume that:
1. F is increasing in K and L
2. F is concave in K and L; in other words, MPL decreases with L and
MPK decreases with K, where:
MPL =

F
(K, L) = F (K, L + 1) F (K, L)
L

MP K =

F
(K, L) = F (K + 1, L) F (K, L)
K

and

The production function is often assumed to display constant returns to


scale:
F (2K, 2L) = 2F (K, L) = 2Y
F (zK, zL) = zF (K, L) = zY.
Example: Cobb-Douglas

F (K, L) = K L1 ,

where
0 < < 1.
For given supply of labor L = L and given supply of capital K = K, we
thus obtain the aggregate supply of goods and services:
Y = F (K, L).
Here we take the production technology to be invariant; however, we shall
remove this assumption when we analyze economic growth.

How is national income distributed to the factors of production?


Factor prices are the amounts paid to the factors of production. How are
they determined?
by the intersection between supply and demand for these factors.
Supplies of capital and labor are fixed, but demands result from profitmaximization decisions by firm.
When deciding how much services from the factors of production to purchase, each individual firm takes the price of the good it sells and the
prices of the factor services it purchases, as given.
= unit price of good p, wage w (unit price of labor) and rental price of
capital r (unit price of capital) are taken as given.
Note that we implicitly assume that capital is owned by households, and
that firms rent that capital.
Representative firm solves:
max{pF (K, L) wL rK}
K,L

For given K, firm increases L until


Profit = Revenue Cost
= p.M P L w
= 0
=
MP L =

F
(K, L) = w/p = real wage.
L

Similarly, for given L, firm increases K until


Profit = Revenue Cost
= p.M P K r
= 0
=
MP K =

F
(K, L) = r/p = real rental price of capital.
K

Therefore each factor is paid its marginal productivity.


Cobb-Douglas case:
M P L = (1 )(K/L) = w/p;
M P K = (L/K)1 = r/p.
this system determines K = K d and L = Ld as decreasing functions
of w/p and r/p respectively.
Eulers Theorem: if the production has the property of constant returns
to scale then economic profit is equal to zero; in other words, once each
factor has been paid its marginal product, there is nothing left, the output
is fully exhausted.
F (K, L) = (M P K).K + (M P L).L.
Proof in Cobb-Douglas case:
(M P K)K + (M P L)L = K 1(1) L1
+(1 )K L1
= K L1
Note that this is economic profit, not necessarily accounting profit: namely,
if firms own the capital they use instead of renting it, then:
Accounting profit = Economic Profit + (M P K).K.
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The demand for goods and services

3.1

Consumption

Disposable income:

Y T.

This disposable income is divided between consumption and savings.


Consumption function:

C = C(Y T ),

where C is increasing. We often assume that this function is linear, of the


form:
C = c0 + c1 (Y T ).
Marginal propensity to consume:
MPC =

C
= c1 .
(Y T )

and (1 c1 ) is the marginal propensity to save.

3.2

Investment

Firms buy investment goods to add to their stock of capital or to replace


obsolete machines.
Investment demand depends negatively upon the interest rate, which measures the cost of funds to finance investment.
Opportunity cost of investing own funds is increasing in r

because the firm could instead decide to invest its funds in bank
deposits at interest rate r
the higher r, the smaller the number of investments projects that are
more attractive than investing in bank deposits

Cost of borrowing is increasing in r

because lenders have the alternative of putting the funds in bank


deposits and the firm must give them at least as much as what they could
get from the bank
the higher r, the more firms must pay their lenders and therefore
the smaller the number of investors who will be able to aord the cost of
investment

Nominal interest rate: the rate that investors pay to borrow money
Real interest rate: nominal interest rate corrected for the eects of inflation.
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Investment function:

I = I(r),

where r = i denotes the real interest rate.

3.3

Government purchases

Subject to political economy considerations that we abstract from here


= we fix:

G = G;
T = T.
Balanced budget if and only if:
G = T.
Budget deficit if

G > T;

Budget surplus if
G < T.

Market equilibrium
The condition for equilibrium on the market for goods and services is
simply:
Y = C + I + G,
(1)
where
1. the left-hand side of (1) is the aggregate supply of goods and services
determined by the production function, that is by:
Y = F (K, L);
2. consumption demand is determined by:
C = c0 + c1 (Y T );
3. investment demand is determined by:
I = I(r);
4. and G is the amount of government purchases, which we fix at G.

We can reexpress equation (1) as:


Y =

1
[c0 + I(r) + G c1 T ],
1 c1

where:
1. the term in brackets represents the demand for goods if output were
equal to zero; this term is called autonomous spending, to capture
the idea that it is the component of demand that does not depend
on the level of output;
1
2. the factor 1c
, which is a number greater than one, is called the
1
multiplier; it captures the fact that in the short run, that is for
fixed price, an increase in autonomous spending, e.g from increases
in government spending or from tax reductions, induces an increase
in output which is bigger than the increase in autonomous spending. The idea is that the increase in autonomous demand leads to an
increase in production and income, which in turn increases consumption demand and therefore income... but remember that here we are
primarily interested by the long run where prices are flexible and
therefore income supply is ultimately determined by factor supply,
fixed at
Y = F (K, L).

In this case, the only eect of an increase in autonomous demand is


to increase the interest rate r.
To better understand the role of the interest rate in clearing the market
for goods and services, let us rewrite equation (1) as:
Y C G = I.

(2)

The left-hand side of (2) is the output that remains after the demands of
consumers and government have been satisfied; it is called national savings
or simply savings. This equation is thus of the form:
Savings = Investment,
or the IS relation.
Going one step further, let us rewrite (2) as:
(Y T C) + (T G) = I,
where the first term on the left-hand side is disposable income minus
consumption, which is private savings, and the second term on the left
hand side is government revenue minus government spending, which is
public savings. The equation thus says that the flows into the financial
markets (private and public savings) is equal to the flow out of the financial
markets (investment).
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Equilibrium interest rate when capital stock and labor supply are fixed:
then we have
Y = Y = F (K, L),
and, from (2):
Y c0 c1 (Y T ) G = S = I(r)
= Figure 3-8.
Comparative statics:
1. An increase in government purchases G shifts the Savings line to
the left (it reduces total savings) which in turn reduces the supply
of funds, and thus pushes the interest rate upward so as to reduce
investment demand accordingly. Thus the increase in government
purchase causes the interest rate to rise and private investment demand to decrease. We say that government purchases crowd out
investment demand. See Figure 3-9
2. A reduction in taxes raises disposable income and therefore consumption demand, namely by the reduction in taxes times the marginal
propensity to consume c1 . Again, this leads to a lower level of total
savings, which therefore must be met by lower investment demand
and therefore by a higher interest rate.
3. An increase in investment demand (for example because of a new
technological innovation or because government encourages investment through tax credits), shifts the investment curve upward, and
therefore simply raises the equilibrium interest rate.
= Figure 3-11
4. A simple variant of this latter case, is to assume that savings also depends on the interest rate (a higher interest rate encourages savings);
then an increase in investment demand raises both, the interest rate
and the equilibrium investment.
= Figure 3-12.
Short-run equilibrium: in the short run prices are rigid and therefore output Y is not determined by factor supply but instead by aggregate demand.
In this case, equilibrium on the goods market is expressed by the equation:
S(Y ) = I(r),
where
S(Y ) = Y co c1 Y G.
Equation (2) is referred to as the IS curve.

(3)

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