Macroeconomics

1
Macroeconomics The Global EconomyTerm IIIAce
Institute of ManagementChapter 3 National
income-where it comes and where it goes?

• Instructor
• Sandeep Basnyat
• Sandeep_basnyat_at_yahoo.com
• 9841 892281

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)
Consumption Expenditure (C)
Market for goods and Services
National Products
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?Our
first theorythe Neo classical theory (based on
classical theory)
5
Welcome to...
The Classical Factory
The place where Classical-model mechanics are
made easy!
6
What is the Classical Model?

• Its roots go back to 1776to Adam Smiths 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?
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 economys 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 gt zY1
• If decreasing returns to scale, Y2 lt zY1

12
Other assumptions of the model

1. Technology is fixed.
2. The economys 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.
What about demand?
19
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)

• DefThe 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 function
Y output
MPL
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
Each firm hires labor up to the point where P
MPL (VMPL) W MPL W/P
25
The 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 firms demand curve for
  renting capital.
• Firms maximize profits by choosing K such that
  MPK R/P .

27
The equilibrium real rental rate
The real rental rate adjusts to equate demand
for capital with supply.
28
How income is distributed

• total labor income

total capital income
If production function has constant returns to
scale, then
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 aY Labor Income MPL
L (1- a) Y
31
CobbDouglas Production Function
Capital Income MPK K a Y Labor Income MPL
L (1- a) Y
a is a constant and measures capital and labors
share of income.
Cobb showed that the function with this property
is F (K, L) A Ka L1- a
Cobb-Douglas Production Function
A is a parameter that measures the productivity
of the available technology. (Total Factor
Productivity)
32
CobbDouglas Production Function
CobbDouglas Production Function Y F (K, L)
A Ka L1- a Differentiating, we get the
Marginal product of labor MPL (1- a) A Ka La
Multiply and Divide right hand side by L.
Then, MPL (1- a) A Ka La L / L (1- a) A
Ka L1-a / L MPL (1- a) Y / L Similarly, The
Marginal product of capital is MPK a A
Ka-1L1a or, MPK a Y/K
Average Labour Productivity
Average Capital Productivity
33
Properties of the CobbDouglas Production Function
(1) Consider the CobbDouglas production
function MPL (1- a)Y/L .(i) MPK a
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 CobbDouglas Production Function
2) The CobbDouglas 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 Ka L1- a F(zK,zL) A(zK)a
(zL)1- a F(zK,zL) Az a Kaz1- aL1- a F(zK,zL)
Az a z1- a KaL1- a F(zK,zL) Az a1- a KaL1-
a F(zK,zL) Az KaL1- a zA KaL1- a zF(K,L)
zY Therefore, Cobb-Douglas production function
has constant returns to scale.
35
Empirical Evidence of the CobbDouglas Production
Function

• According to C.D. Prod. Func. MPL a Y/L
• According to Neo Classical Theory, MPL W /P
• So, MPL a W/P

Growth in Labour productivity and Real Wages in
US Period Labour Productivity Real
Wages Growth rate Growth rate 1959-1973 2.9
2.8 1973-1995 1.4 1.2 1995-2003 3.0
3.0 1995-2003 2.1 2.0 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
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 ones
  own funds to finance investment spending.
• So, ?r ? ?I

41
The investment function
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 gt G , budget surplus (T G )
  public saving
• When T lt 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 investmentFirms 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 curve
The investment curve is also the demand curve for
loanable funds.
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
National saving does not depend on r, so the
supply curve is vertical.
51
Loanable funds market equilibrium
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 eqm)
• Thus,

53
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
1. The increase in the deficit reduces saving
2. which causes the real interest rate to rise
3. which reduces the level of investment.
I2
I1
55
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
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 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 a 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
Solutions for Practice

• 3) An economy's production function is
  cobb-douglas with parameter a 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 a 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 a 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