ECON100B

Macroeconomics
Week Two & Three

Chapter 3: National Income

 Where It Comes From and Where It Goes

▪ What determines the economy’s total output/income

▪ How the prices of the factors of production are
determined
▪ How total income is distributed
▪ What determines the demand for goods and
services
▪ How equilibrium in the goods market 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 production function: 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
K = capital: tools, machines, and structures used in
production

L = labor: the physical and mental efforts of workers

Returns to scale: a review
Initially Y1 = F (K1 , L1)
Scale all inputs by the same factor z > 1:
K2 = zK1 and L2 = zL1
(e.g., if z = 1.2, then all inputs are increased by 20%)

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
NOW YOU TRY
Returns to Scale
• F K, L = 𝐾 + 𝐿

F zK, zL = 𝑧𝐾 + 𝑧𝐿 = 𝑧 𝐾 + 𝐿 = 𝑧𝐹(𝐾, 𝐿)

• F K, L = KL

F zK, zL = zK zL = z 2 KL = z KL = zF K, L

• F K, L = K 2 + L2

F zK, zL = zK 2 + zL 2 = z 2 K 2 + L2 = z 2 F K, L
 Assumptions
1. Technology is fixed.
2. The economy’s supplies of capital and labor
are fixed at: 𝐾 = 𝐾 and 𝐿 = 𝐿
Output is determined by the fixed factor supplies
and the fixed state of technology: 𝑌 = 𝐹(𝐾, 𝐿)
▪ The distribution of national income is determined by
factor prices, the prices per unit firms pay for the
factors of production
▪ wage = price of L
▪ rental rate = price of K
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?

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
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

▪ Marginal product of labor (MPL): the extra output the firm

can produce using an additional unit of labor (holding
other inputs fixed): MPL = ∂F(K, L)/∂L
▪ MPL = ∆Y/∆L
NOW YOU TRY
Compute & graph MPL
L Y MPL
a. Determine MPL at each 0 0 n.a.
value of L. 1 10 10
b. Graph the production 2 19 9
function. 3 27 8
4 34 7
c. Graph the MPL curve with 5 40 6
MPL on the vertical axis and
6 45 5
L on the horizontal axis.
7 49 4
d. MPL=∆Y/∆L 8 52 3
e. MPL (L=1): (10-1)/(1-0) 9 54 2
10 55 1
 ANSWERS
Compute & graph MPL

Marginal Product of Labor

Production function

MPL (units of output)

Output (Y)

60 12

50 10
40 8
30 6
20
4
10
2
0
0 1 2 3 4 5 6 7 8 9 10 0
0 1 2 3 4 5 6 7 8 9 10
Labor (L) Labor (L)
 MPL and the production function
Y
output As more labor is
added, MPL falls 𝑭(𝑲, 𝑳)
As one input
is increased MPL
(holding 1 Intuition: If L
other inputs MPL increases while
constant), its holding K fixed
1
marginal machines per
product falls. worker falls,
Slope of the production worker
MPL
function equals MPL productivity
falls.
1
L
labor
 Example
Identifying diminishing returns
Which of these production functions does not have diminishing
marginal returns to labor?

1. 𝐹 𝐾, 𝐿 = 2𝐾 + 15𝐿

No, MPL = 15 for all L

2. 𝐹(𝐾, 𝐿) = 𝐾𝐿

Yes, MPL falls as L rises

3. 𝐹(𝐾, 𝐿) = 2 𝐾 + 15 𝐿

Yes, MPL falls as L rises

NOW YOU TRY
MPL and labor demand L Y MPL
0 0 n.a.
Suppose W/P = 6. 1 10 10
2 19 9
▪ If L = 3, should firm hire
3 27 8
more or less labor? Why?
4 34 7
▪ If L = 7, should firm hire 5 40 6
more or less labor? Why? 6 45 5
7 49 4
8 52 3
9 54 2
10 55 1
ANSWERS
MPL and labor demand L Y MPL
0 0 n.a.
If L = 3, should firm hire more or less 1 10 10
labor? 2 19 9
Answer: 3 27 8
MORE, because the benefit of the 4 34 7
4th worker (MPL = 7) exceeds its 5 40 6
cost (W/P = 6) 6 45 5
7 49 4
If L = 7, should firm hire more or less
labor? 8 52 3
9 54 2
Answer: LESS, because the 7th
10 55 1
worker adds MPL = 4 units of output
but costs the firm W/P = 6.
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
The equilibrium real wage
Units of Labor
output The real wage
supply
adjusts to equate
labor demand
with supply.

Equilibrium
real wage MPL,
Labor
demand
𝑳 Units of labor, L
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 falls as K rises
▪ The MPK curve is the firm’s demand curve
for renting capital.
▪ Firms maximize profits by choosing K
such that MPK = R/P.
 The equilibrium real rental rate
Units of
output Supply of The real rental rate
capital adjusts to equate
demand for capital
with supply.

equilibrium
R/P MPK,
demand for
capital
𝑲 Units of capital, K
The neoclassical theory of distribution
▪ States that each factor input is paid its marginal product
▪ A good starting point for thinking about income distribution
▪ Total labor income = 𝑊𝑃 𝐿 = 𝑀𝑃𝐿 × 𝐿

▪ Total capital income = 𝑅𝑃 𝐾 = 𝑀𝑃𝐾 × 𝐾

▪ If production function has constant returns to scale, then
𝑌 = 𝑀𝑃𝐿 × 𝐿 + 𝑀𝑃𝐾 × 𝐾

national labor capital

income income income
The ratio of labor income to total
income in the United States, 1960–2019

Labor’s share of income

is approximately constant over time.
(Thus, capital’s share is, too.)

Available: https://fred.stlouisfed.org/series/LABSHPUSA156NRUG
 The Cobb-Douglas production function
▪ The Cobb-Douglas production function has constant factor shares:
α = capital’s share of total income:
capital income = MPK × K = αY
labor income = MPL × L = (1 – α)Y
▪ The Cobb-Douglas production function is: 𝒀 = 𝑨𝑲𝜶 𝑳𝟏−𝜶
where A represents the level of technology.
▪ Each factor’s marginal product is proportional to its average
product:
𝛼𝑌
𝑀𝑃𝐾 = 𝛼𝐴𝐾 𝛼−1 𝐿1−𝛼 =
𝐾
(1 − 𝛼)𝑌
𝑀𝑃𝐿 = (1 − 𝛼)𝐴𝐾 𝛼 𝐿−𝛼 =
𝐿
Labor productivity and wages
▪ Theory: wages depend on labor productivity
U.S. data:
Time Period Growth Rate of Growth Rate of
Labor Real Wages
Productivity
1960-2019 2.0% 1.8%
1960-1973 3.0 2.7
1973-1995 1.5 1.2
1995-2010 2.7 2.2
2010-2019 0.9 1.0

Source: U.S. Department of Labor

The growing gap between rich & poor
0.50

Inequality has been rising

0.45
in recent decades.

0.40

Gini coefficient
0.35

0.30
 Explanations for rising inequality
1. Rise in capital’s share of income, since capital income is more
concentrated than labor income
2. From The Race Between Education and Technology by Claudia Goldin &
Lawrence F. Katz

▪ Technological progress has increased the demand for skilled relative to

unskilled workers. Due to a slowdown in expansion of education, the
supply of skilled workers has not kept up.
▪ Result: Rising gap between wages of skilled and unskilled workers.
Demand for goods and services
Components of aggregate demand:
C = consumer demand for goods & services
I = demand for investment goods & services
G = government demand for goods & services
(closed economy: no NX )
Consumption, C
▪ Disposable income is
total income minus total
taxes: Y – T.
▪ Consumption function:
C = C(Y – T )
▪ Definition: Marginal
propensity to
consume (MPC) is the
change in C when
disposable income
increases by one dollar.
 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, I depends negatively on r
Here r is the real interest rate, not
the rental rate of capital (R)
Government spending, G
▪ G = government 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 and 𝑇=𝑇
The market for goods & services
▪ Aggregate demand: 𝐶(𝑌 − 𝑇) + 𝐼(𝑟) + 𝐺

▪ Aggregate supply: 𝑌 = 𝐹(𝐾, 𝐿)

▪ Equilibrium: 𝑌 = 𝐶(𝑌 − 𝑇) + 𝐼(𝑟) + 𝐺

The real interest rate adjusts to equate demand

with supply.
 Demand and Supply for funds
▪ The loanable funds market: a simple supply–demand model of the
financial system.
▪ One asset: loanable funds
▪ price of funds: r
▪ The demand for loanable funds comes from I:
▪ Firms borrow to finance spending on plant & equipment, new
office buildings, etc. Consumers borrow to buy new houses.
▪ The demand depends negatively on r, the cost of borrowing.
▪ The supply of loanable funds comes from S:
▪ Households use their saving to make bank deposits, purchase
bonds and other assets.
▪ The government may contribute to saving if it has a fiscal
surplus.
 Loanable funds demand curve

The investment curve is also the demand curve for loanable

funds.
 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

▪ 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 U.S. government finances its deficit by issuing Treasury
bonds–i.e., borrowing.
U.S. federal government surplus/deficit,
1930-2020

Data source: https://fred.stlouisfed.org/series/FYFSGDA188S

U.S. federal government debt, 1940-2019

Data Source: https://fred.stlouisfed.org/series/GFDGDPA188S

Loanable funds market equilibrium
r 𝑺 = 𝒀 − 𝑪(𝒀 − 𝑻) − 𝑮

National saving
does not
depend on r,
Equilibrium real so the supply
interest rate curve is vertical.

I (r )
Equilibrium level S, I
of investment
The special role of r
r adjusts to equilibrate the goods and services market
and the loanable funds market simultaneously:
If the loanable funds market is in equilibrium, then
Y–C–G=I
Add (C +G ) to both sides to get
Y = C + I + G (goods and services market equilibrium)
Thus,

Equilibrium in Equilibrium in
loanable funds goods and services
market market
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: 401(k), IRA, replace income
tax with consumption tax
Things that shift the investment curve:
▪ some technological innovations
▪ to take advantage of some innovations, firms must buy
new investment goods
▪ tax laws that affect investment: e.g., investment tax credit
CASE STUDY:
The Reagan Deficits
▪ Reagan policies during early 1980s:
▪ increases in defense spending: ΔG > 0
▪ big tax cuts: ΔT < 0
▪ Both policies reduce national saving:
𝑆 = 𝑌 − 𝐶(𝑌 − 𝑇) − 𝐺

▪ ↑ 𝐺ሜ ⇒ ↓ 𝑆ሜ
▪ ↓ 𝑇ሜ ⇒ ↑ 𝐶 ⇒ ↓ 𝑆ሜ
CASE STUDY:
The Reagan Deficits
1. The increase in r 𝑺𝟐
𝑺𝟏
the deficit
reduces saving…

r2
2. …which causes
the real interest
r1
rate to rise…

3. …which reduces I (r )
the level of I2 I1 S, I
investment.
An increase in investment demand
r 𝑺

…raises the An increase

interest rate. r2 in desired
investment…
r1
But the equilibrium
level of investment I2
cannot increase I1
because the supply
S, I
of loanable funds is
fixed.
Saving and the interest rate
▪ Why might saving depend on r ? How would the results of an
increase in investment demand be different?
1) An increase in r makes S more attractive and increases the
reward for postponing C.
2) An increase in r makes borrowing more expensive.
3) However, an increase in r might also reduce saving through the
income effect: A higher r makes net savers better off, so they
purchase more of all “normal” goods. If current consumption is a
normal good, then it will rise and S will fall.
It is usually assumed that the substitution effect is at least as great as
the income effect, so that an increase in r will either increase S or
leave S unchanged.
An increase in investment demand when
saving depends on r

r
An increase in 𝑺(𝒓)
investment demand
raises r, which
induces an increase
r2
in the quantity of
saving, which allows r1
I to increase.
I(r)2
I(r)1
I1 I2 S, I
Notation: Δ = change in a variable
▪ For any variable X, ΔX = “change in X ”
Δ is the Greek (uppercase) letter Delta
Examples:
▪ ΔY = MPL × ΔL + MPK × ΔK
▪ Δ preserves linear relationship
▪ Δ(Y − T ) = ΔY − ΔT , so MPC: Marginal
Propensity to

▪ ΔC = MPC × (ΔY − ΔT ) Consume

= MPC ΔY − MPC ΔT
 NOW YOU TRY
Calculate the change in saving
Suppose MPC = 0.8 and MPL = 20. For each of the following, compute ΔS :
a. ΔG = 100 b. ΔT = 100 c. ΔY = 100 d. ΔL = 10
ΔC = MPC × (ΔY − ΔT )
Δ𝑆 = Δ𝑌 − Δ𝐶 − Δ𝐺 = Δ𝑌 − 0.8(Δ𝑌 − Δ𝑇) − Δ𝐺 = 0.2Δ𝑌 + 0.8Δ𝑇 − Δ𝐺
a. If ΔG = 100 then Δ𝑆=−100 (due to increased government spending, ΔS=−ΔG=−100)

b. If ΔT = 100 then Δ𝑆=80 (0.8*100=80)

c. If ΔY = 100 then Δ𝑆=20, (due to increased overall income, Δ𝑆 = 0.2 × 100 = 20 )

d. If ΔL = 10 then Δ𝑆=40 (due to increased labor increasing income, Δ𝑌 = MPL × Δ𝐿 =

20 × 10 = 200, Δ𝑆 = 0.2 × Δ𝑌 = 0.2 × 200 = 40.)