National Income: Where It

Comes From and Where It

Goes
Chapter 3 of Macroeconomics,
8th edition, by N. Gregory
Mankiw
ECO62 Udayan Roy
 Chapter Outline
In chapter 2, we saw that Y = C + I
+ G + NX
In this chapter, we will see
a long-run theory of Y, and
a long-run theory of how Y is split
between C, I and G
For simplicity, this chapter considers a
closed economy, which is an economy
such that NX = 0
I will skip section 3-2!
 Two productive resources and one
produced good
There are two productive resources:
Capital, K
Labor, L
These two productive resources are
used to produce one
final good, Y
 The Production Function
The production function is an
equation that tells us how much of
the final good is produced with
specified amounts of capital and
labor Y = 5K L 0.3 0.7

Y = F(K, L) labor
0 10 20 30
Example: Y = AK L
0.3 capita
0.7
l 0 0 0 0 0
A represents technology 1 0 25.06 40.71 54.07

Y = 5K0.3L0.7, when A = 5 2 0 30.85 50.12 66.57

3 0 34.84 56.60 75.18
4 0 37.98 61.70 81.95
 Constant returns to scale
Y = 5K0.3L0.7
Y = F(K, L) = labor
5K0.3L0.7 0 10 20 30
capita
Note: l 0 0 0 0 0
if you double both K and 1 0 25.06 40.71 54.07
L, Y will also double 2 0 30.85 50.12 66.57
if you triple both K and L, 3 0 34.84 56.60 75.18
Y will also triple 4 0 37.98 61.70 81.95
and so on
This feature of the Y = It is common in
5K0.3L0.7 production economics to
function is called assume that
constant returns to production functions
scale obey constant
returns to scale
 Constant returns to scale
Definition: The production function F(K, L)
obeys constant returns to scale if and only if
for any positive number z, F(zK, zL) = zF(K, L)

Example: Suppose F(K, L) = 5K0.3L0.7.

Then, for any z > 0, F(zK, zL) = 5(zK)0.3(zL)0.7 =
5z0.3K0.3z0.7L0.7 = 5z0.3 + 0.7K0.3L0.7 = z5K0.3L0.7 = zF(K,
L)
Therefore, F(K, L) = 5K0.3L0.7 obeys constant
returns to scale
 GDP in the long run:
assumptions

is the exogenous stock of physical
capital that the economy has inherited
as a result of historical decisions to
invest in physical capital

is the exogenous amount of labor at

work
Let us say that P is the labor force and u
is the long-run unemployment rate.
Then, .
 GDP in the long run:
assumptions
Y is endogenous
K, L, F(K, Y
Therefore, is one equation with oneL)
endogenous variable
Therefore, it completes the theory
Predictions
of GDP in the long run Grid
Yes, it really is that simple! GDP,
Y
Capital, K +
Example: Suppose F(K, L) = Labor, L +
5K0.3L0.7. Technolog +
If K = 2 and L = 10, then Y = 30.85. y
 GDP in the long run:
assumptions
The assumption that K and L are
exogenous is significant
It basically is the assumption that in
the long run, the amount of capital
and labor used in production
depends only on how much capital
and labor the economy has
This assumption is not made in short-
run theories
 Consumption Expenditure
Now that we know what determines
total output (Y), the next question is:
What happens to that output?
In particular, what determines how
much of that output is consumed?
What determines C?
Consumption, C
Net Taxes = Tax Revenue Transfer
Payments
Denoted T and always assumed exogenous
Disposable income (or, after-tax
income) is total income minus net taxes: Y
T.
Predictions Grid
Assumption: Consumption expenditure Y C
is directly related to disposable
Capital, K + +
income Labor, L + +
Technolog + +
y
Taxes, T
The Consumption Function
C

C (Y T )

The slope of the

MPC
consumption function
1 is the MPC.

YT
Marginal propensity to consume The MPC is usually a
(MPC) is the increase in consumption positive fraction: 0 <
(C) when disposable income (Y T) MPC < 1.
Consumption, C
Assumption: Consumption
expenditure is directly related to
disposable income
Consumption function: C = C (Y T )
Specifically, C = Co + Cy (Y T)
Co represents all other exogenous
Predictions Grid
variables that affect consumption,
Y C
such as asset prices, consumer
optimism, etc. Capital, K + +
Labor, L + +
Cy is the marginal propensity to
consume (MPC), the fraction of every Technolog + +
y
additional dollar of income that is
consumed Taxes, T
Co +
 The Consumption Function
C C = Co2 + Cy(Y
T)
C = Co1 + Cy(Y
T)

Predictions Grid
Y C

, , Technology + +
Taxes,
Taxes, T
T

C
Coo +
+
T1 >
F(K, L) T2 F(K, L) YT
T1 T2
Consumption shift factor: greater
consumer optimism, higher asset prices
 Consumption: example
Suppose F(K, L) = 5K0.3L0.7 and K = 2
and L = 10. Then Y = 30.85.
Suppose T = 0.85. Therefore,
disposable income is Y T = 30.
Private Saving is
Now, suppose C = 2 + 0.8(Y definedasT).
disposable income
Then, C = 2 + 0.8 30 = minus
26
consumption, which
is Y T C = 30
K, L, F(K, Y 26 = 4.
L) C
C(Y T),
T
 Marginal Propensity to
Consume
The marginal propensity to consume
is a positive fraction (1 > MPC > 0)
That is, when income (Y) increases,
consumption (C) also increases, but
by only a fraction of the increase in
income.
Therefore, Y C and Y Predictions
C Grid
Y C Y
Similarly, Y C and Y C C
K, L, + + +
Technology
Taxes, T +
 Government Spending
Assumption: government spending
(G) is exogenous
Public Saving is defined as the net
tax revenue of the government
minus government spending, which
is T G
 National Saving and
Investment
In chapter 2, we saw that Y = C + I
+ G + NX
In this chapter, we study a closed
economy: NX = 0
Therefore, Y = C + I + G
YCG=I
Y C G is defined as national
saving
K, L, F(K,
(S)
Y
G
S=I=Y
L)Therefore, S = I C CG
C(Y T),
 Investment: example
Suppose F(K, L) = 5K0.3L0.7 and K = 2
and L = 10. Then Y = 30.85.
Suppose T = 0.85. Therefore,
disposable income is Y T = 30.
Public Saving
Now, suppose C = 2 + 0.8(Y =TG =T).
0.85
3 = 2.15
Then, C = 2 + 0.8 30 = 26
Suppose G = 3
Then, I = S = Y C G = 30.85
26 3 = 1.85
At this point, you should be able to do problem 8 on page
80 of the textbook.
 Saving and Investment:
Predictions
Predictions Grid Predictions Grid
Y C Y Y C Y YC
C C G
K, L, + + + K, L, + + + +
Technology Technology
Taxes, T + Taxes, T + +
Co + Co +
Govt, G
Predictions Grid
Y C S,
I
K, L, + + +
Technology
Taxes, T +
C +
 The Real Interest Rate
Imagine that lending and borrowing take
place in our economy, but in commodities,
not cash
That is, you may borrow some amount of the
final good, as long as you pay back the quantity
you borrowed plus a little bit extra as interest
The real interest rate (r) is the fraction of
every unit of the final good borrowed that
the borrower will have to pay to the lender
as interest
 The nominal interest rate
The interest rate that a bank charges
you for a cash loan is called the
nominal interest rate (i)
It is the fraction of every dollar borrowed
that the lender must pay in interest
The nominal interest rate is not
adjusted for inflation
I will discuss the long-run theory of
the nominal interest rate in Chapter
5
 Investment and the real interest
rate
Assumption: investment spending
is inversely related to the real
interest rate
Ir = I(r), such that r I

I (r
)
I
 Investment and the real interest
rate
Specifically, I = Io Irr
Here Ir is the effect of
r
r on I and
Io represents all
other factors that Io2
also affect business Irr
investment spending Io1
such as business Irr
optimism, technological I
progress, etc.
 The Real Interest Rate:
example
Suppose F(K, L) = 5K0.3L0.7 and K = 2 and L =
10. Then Y = 30.85. Suppose T = 0.85.
Therefore, disposable income is Y T = 30.
Now, suppose C = 2 + 0.8(Y T). Then, C
= 2 + 0.8 30 = 26
Suppose G = 3. Then, I = S = Y C G =
30.85 26 3 = 1.85
Suppose I = 11.85 2r is the investment
function
Then, 11.85 2r = 1.85. Therefore, r = 5
percent
At this point, you should be able to do problems 9, 10, and 11 on
page 80 of the textbook.
 Whole chapter in one slide!

which gives
Predictions Grid
Y C S, I r
K, L, A + + +
(Technology)
Net Taxes, T +
Co + +
Govt Spending, +
 The Real Interest Rate
Recall that the amount of investment
has already been determined
The investment function can
therefore be used to determine the
real interest rate

I(r)
G r
K, L, F(K, Y S=I=Y
L) C CG
C(Y T),
 The Real Interest Rate
I = Y C(Y-T) G
r Predictions Grid
I = F(K, L) C(F(K, L)
Y C S, I r
T) G
K, L, + + +
Technology
Taxes, T +
I(r) = Io Co + +
Irr
Govt, G +
I
Io +

I(r)
G r
K, L, F(K, Y S=I=Y
L) C CG
C(Y T),
 The Real Interest Rate:
predictions
Predictions Grid
As investment Y C S, I r
and the real K, L, + + +
Technology
interest rate are Taxes, T +
inversely related, Co + +
any exogenous Govt, G +
variable that Io +
Q: Why is it that
affects business optimism or
investment one technological progress
shifts the investment
way will affect curve upwards, but does
the real interest not affect the amount of
investment in the long
 The Real Interest Rate:
predictions
Predictions Grid
The amount of Y C S, I r

business investment K, L, + + +
Technology
has already been Taxes, T +
determined Co + +
So, any increase in Govt, G +
business optimism I r +
o
I = F(K, L) C(F(K, L)
must be cancelled T) G
out by an increase
Io2
in the real interest
Irr
rate Io1
Irr
I
 Looking at all aspects of an
economy
The result that an increase in
businesses desire to invest may not
lead to more investment shows the
benefit of the macroeconomic
approach
The S = I link between saving by the
non-business sector and investment
spending by the business sector
leads to a surprising result
 The long-run models
predictions
Predictions Grid
This is it! Y C S, I r
K, L, + + +
Technology
Taxes, T +
Co + +
Govt, G +
Io +
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 U.S. government finances its
U.S. Federal Government
Surplus/Deficit, 1901-2014
 U.S. Federal Government
Surplus/Deficit, 1940-2013 (% of GDP)
U.S. Federal Government
Debt
U.S. Federal Government Debt,
1940-2012 (% of GDP)
CASE STUDY:
The Reagan deficits
Reagan policies during early 1980s:
increases in defense spending: G > 0
big tax cuts: T < 0
Both policies reduce national saving:
S Y C (Y T ) G

G S T C S
CASE STUDY:
The Reagan deficits
1.
1. The
The increase
increase in
in r S1
S2
the
the deficit
deficit
reduces
reduces
saving
saving
r2
2.
2. which
which causes
causes
the
the real
real interest
interest r1
rate
rate to
to rise
rise

3.
3. which
which I (r )
reduces
reduces the
the I2 I1 S, I
level
level of
of
investment.
investment.
Are the data consistent with these results?

variable 1970s 1980s

TG 2.2 3.9
S 19.6 17.4
r 1.1 6.3
I 19.9 19.4

TG, S, and I are expressed as a percent of GDP

All figures are averages over the decade shown.
NOW YOU TRY:
The effects of saving incentives
Draw the diagram for the loanable funds
model.
Suppose the tax laws are altered to provide
more incentives for private saving.
(Assume that total tax revenue T does not
change)
What happens to the interest rate and
investment?
FYI: Markets, Intermediaries, the 2008 Crisis
In the real world, firms have several options
for raising funds they need for investment,
including:
borrow from banks
sell bonds to savers
sell shares of stock (ownership) to
savers
The financial system includes:
bond and stock markets, where savers
directly provide funds to firms for
investment
financial intermediaries, e.g. banks,
FYI: Markets, Intermediaries, the 2008 Crisis

Intermediaries can help move funds

to their most productive uses.
But when intermediaries are
involved,
savers usually do not know what
investments their funds are
financing.
Intermediaries were at the heart of
the financial crisis of 2008.
FYI: Markets, Intermediaries, the 2008 Crisis

A few details on the financial crisis:

July 06 to Dec 08: house prices fell
27%
Jan 08 to Dec 08: 2.3 million
foreclosures
Many banks, financial institutions
holding mortgages or mortgage-
backed securities
driven to near bankruptcy
Congress authorized $700 billion to
help shore up financial institutions
NOMINAL AND REAL INTEREST RATES
AND INFLATION EXPECTATIONS
 The Nominal Interest Rate
Suppose you borrow $100 today and promise
to pay back $110 a year from today
Here i = 0.10
If prices are low a year from today, the
purchasing power of the $10 you pay in interest
will be high. So, you will regret the loss
If prices are high a year from today, the
purchasing power of the $10 you pay in interest
will be low. You will not regret the loss as much
 The Real Interest Rate
In the case of cash loans, the real interest
rate is the inflation-adjusted interest rate
To adjust the nominal interest rate for
inflation, you simply subtract the inflation
rate from the nominal interest rate
If the bank charges you 5% interest rate on a cash
loan, thats the nominal interest rate (i = 0.05).
If the inflation rate turns out to be 3% during the
loan period ( = 0.03), then you paid the real
interest rate of just 2% (r = i = 0.02)
 The Real Interest Rate
Unfortunately, when you are taking out a
cash loan you dont quite know what the
inflation rate will be over the loan period
So, economists distinguish between
the ex post real interest rate: r = i
and the ex ante real interest rate: r = i
E, where E is the expected inflation
rate over the loan period
See pages 110113 of the textbook for more
on this
Real Interest Rate
Nominal Interest Rate

Nomin
al

Rea
l
Inflation Expectations,
inferred

Nomina
l

Real

Nominal Real = Expected

Inflation
Inflation Expectations, direct
Inflation Expectations, inferred and
direct
Inflation Expectations, inferred and
direct