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Mankiw 6e PowerPoints

CHAPTER 3 National Income
The material in this chapter is the basis of much of the remaining material in this book. So, the time your students spend mastering this material will pay dividends throughout the semester.

This PowerPoint contains many in-class exercises to break up the lecture and help students learn the concepts. Depending on your students’ backgrounds, some of these exercises may be too easy. You can “hide” or delete the corresponding slides to get through the chapter more quickly.

IN THIS CHAPTER, YOU WILL LEARN:
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

CHAPTER 3 National Income

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

It’s useful for students to keep in mind the big picture as they learn the individual components of the model in the following slides.

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

In the simple model of this chapter, we think of capital as plant & equipment. In the real world, capital also includes inventories and residential housing, as discussed in Chapter 2.

Students may have learned in their principles course that “land” or “land and natural resources” is an additional factor of production. In macroeconomics, we mainly focus on labor and capital, though. So, to keep our model simple, we usually omit land as a factor of production, as we can learn a lot about the macroeconomy despite the omission of land.

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

CHAPTER 3 National Income

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 = 1.2, 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 CHAPTER 3 National Income This review includes 7 slides. If you’d like to shorten this chapter, you might consider skipping a few of these slides. Returns to scale: Example 1 constant returns to scale for any z > 0

CHAPTER 3 National Income

Returns to scale: Example 2

increasing returns to scale for any
z > 1

CHAPTER 3 National Income

NOW YOU TRY
Returns to scale

Determine whether each of these production functions has constant, decreasing, or increasing returns to scale:
(a)
(b)

CHAPTER 3 National Income
To save time, ask half the class to do (a) and the other half to do (b).

To improve learning, pair students up. Ask one student in each to do (a), the other to do (b), then have each one teach their problem to the other.

NOW YOU TRY
Answers, Part (a)

constant returns to scale for any z > 0

CHAPTER 3 National Income

NOW YOU TRY
Answers, Part (b)

constant returns to scale for any z > 0

CHAPTER 3 National Income

Assumptions
Technology is fixed.
The economy’s supplies of capital and labor are fixed at:

CHAPTER 3 National Income

Emphasize that K and L (without bars on top) are variables—they can take on various magnitudes. On the other hand, and are specific values of these variables. Hence, “K = ” means that the variable K equals the specific amount .

Regarding the assumptions:
In the chapters on economic growth, we will relax these assumptions: K and L will grow in response to investment and population growth, respectively, and the level of technology will increase over time.

Determining GDP
Output is determined by the fixed factor supplies and the fixed state of technology:

CHAPTER 3 National Income

Again, emphasize that the notation F(, ) means we are evaluating the function at a particular combination of capital and labor. The resulting value of output is called .

The distribution of national income
determined by factor prices,
the prices per unit firms pay for the factors of production
wage = price of L
rental rate = price of K

CHAPTER 3 National Income

Recall from Chapter 2: The value of output equals the value of income. The income is paid to the workers, capital owners, landowners, and so forth. We now explore a simple theory of income distribution.

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

It might be worthwhile to refresh students’ memory about nominal and real variables.
The nominal wage & rental rate are measured in currency units.
The real wage is measured in units of output.
To see this, suppose W = $10/hour and P = $2 per unit of output.
Then, W/P = ($10/hour) / ($2/unit of output) = 5 units of output per hour of work.
It’s true, the firm is paying the workers in money units, not in units of output. But, the real wage is the purchasing power of the wage—the amount of stuff that workers can buy with their wage.

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

Since the distribution of income depends on factor prices, we need to see how factor prices are determined.
Each factor’s price is determined by supply and demand in a market for that factor. For instance, supply and demand for labor determine the wage.

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

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

NOW YOU TRY
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.
L Y MPL
0 0 n.a.
1 10 ?
2 19 ?
3 27 8
4 34 ?
5 40 ?
6 45 ?
7 49 ?
8 52 ?
9 54 ?
10 55 ?

CHAPTER 3 National Income
This exercise is a pretty basic review. It’s good for students who have not had principles of economics in a few years, and students whose graphing skills could benefit from some remedial attention. Many instructors could probably hide or omit this and the next slide from their presentations.

ANSWERS
Compute & graph MPL

CHAPTER 3 National Income

Marginal Product of Labor
1 2 3 4 5 6 7 8 9 10 10 9 8 7 6 5 4 3 2 1 Labor (L)

MPL (units of output)

Y
output
MPL and the production function

L
labor

1
MPL

1
MPL
As more labor is added, MPL falls
Slope of the production function equals MPL

CHAPTER 3 National Income

It’s straightforward to see that the MPL = the prod function’s slope.

The definition of the slope of a curve is the amount the curve rises when you move one unit to the right. On this graph, moving one unit to the right simply means using one additional unit of labor. The amount the curve rises is the amount by which output increases: the MPL.

Diminishing marginal returns
As one input is increased (holding other inputs constant), its marginal product falls.
Intuition:
If L increases while holding K fixed
machines per worker falls,
worker productivity falls.

CHAPTER 3 National Income

Tell the class: Many production functions have this property.

NOW YOU TRY
Identifying diminishing returns

Which of these production functions have diminishing marginal returns to labor?

CHAPTER 3 National Income

ANSWERS
Identifying diminishing returns

No, MPL = 15 for all L
Yes, MPL falls as L rises
Yes, MPL falls as L rises

CHAPTER 3 National Income
To get the answers:

– Using calculus:
Take the derivative of F( ) with respect to L. The resulting expression is the MPL. Looking at this expression, determine whether MPL falls as L rises. (Or, take derivative of your MPL function w.r.t. L and see whether it’s positive, negative, or zero.)

– Using algebra:
Plug in any value for K and another value for L.
See what happens if you increase L, then increase it again, and again.
This may require a calculator.

– With a graph:
You can sketch the graph of these production functions (Y on the vertical, L on the horizontal, assuming a given value of K). If you know the general shape of the square root function, then it’s easy to tell that (b) and (c) have diminishing marginal returns.

NOW YOU TRY
MPL and labor demand

Suppose W/P = 6.
If L = 3, should firm hire more or less labor? Why?
If L = 7, should firm hire more or less labor? Why?
L Y MPL
0 0 n.a.
1 10 10
2 19 9
3 27 8
4 34 7
5 40 6
6 45 5
7 49 4
8 52 3
9 54 2
10 55 1

CHAPTER 3 National Income

ANSWERS
MPL and labor demand

If L = 3, should firm hire more or less labor?
Answer: MORE, because the benefit of the 4th worker (MPL = 7) exceeds its cost (W/P = 6)
If L = 7, should firm hire more or less labor?
Answer: LESS, because the 7th worker adds MPL = 4 units of output but costs the firm W/P = 6.
L Y MPL
0 0 n.a.
1 10 10
2 19 9
3 27 8
4 34 7
5 40 6
6 45 5
7 49 4
8 52 3
9 54 2
10 55 1

CHAPTER 3 National Income
If L = 3, then the benefit of hiring the fourth worker (MPL = 7) exceeds the cost of doing so (W/P = 6), so it pays the firm to increase L.

If L = 7, then the firm should hire fewer workers: the 7th worker adds only MPL = 4 units of output, yet cost W/P = 6.

The point of this slide is to get students to see the idea behind the labor demand = MPL curve.

MPL and the demand for labor
Each firm hires labor
up to the point where MPL = W/P.

Units of output
Units of labor, L

MPL, Labor demand

Real wage

Quantity of labor demanded

CHAPTER 3 National Income

It’s easy to see that the MPL curve is the firm’s L demand curve.

Let L* be the value of L such that MPL = W/P.

Suppose L < L*. Then, benefit of hiring one more worker (MPL) exceeds cost (W/P), so firm can increase profits by hiring one more worker. Instead, suppose L > L*. Then, the benefit of the last worker hired (MPL) is less than the cost (W/P), so firm should reduce labor to increase its profits.

When L = L*, then firm cannot increase its profits either by raising or lowering L.
Hence, firm hires L to the point where MPL = W/P.
This establishes that the MPL curve is the firm’s labor demand curve.

The equilibrium real wage
The real wage adjusts to equate
labor demand with supply.

Units of output
Units of labor, L

MPL, Labor demand

Equilibrium real wage

Labor
supply

CHAPTER 3 National Income

The labor supply curve is vertical: We are assuming that the economy has a fixed quantity of labor, , whether the real wage is high or low.

Combining this labor supply curve with the demand curve we’ve developed in previous slides shows how the real wage is determined.

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.

CHAPTER 3 National Income

In our model, it’s easiest to think of firms renting capital from households (the owners of all factors of production). R/P is the real cost of renting a unit of K for one period of time.

In the real world, of course, many firms own some of their capital. But, for such a firm, the market rental rate is the opportunity cost of using its own capital instead of renting it to another firm. Hence, R/P is the relevant “price” in firms’ capital demand decisions, whether firms own their capital or rent it.

The equilibrium real rental rate
The real rental rate adjusts to equate
demand for capital with supply.

Units of output
Units of capital, K

MPK, demand for capital

equilibrium R/P

Supply of capital

CHAPTER 3 National Income

The previous slide used the same logic behind the labor demand curve to assert that the capital demand curve is the same as the downward-sloping MPK curve.

The supply of capital is fixed (by assumption), so the supply curve is vertical.

The real rental rate (R/P) is determined by the intersection of the two curves.

The neoclassical theory of distribution
States that each factor input is paid its marginal product
A good starting point for thinking about income distribution

CHAPTER 3 National Income

How income is distributed to L and K
Total labor income =
If production function has constant returns to scale, then
Total capital income =

labor
income

capital
income

national
income

CHAPTER 3 National Income

The last equation follows from Euler’s theorem, discussed in the textbook.

The ratio of labor income to total income in the U.S., 1960-2010
Labor’s share of total income
Labor’s share of income
is approximately constant over time.
(Thus, capital’s share is, too.)

CHAPTER 3 National Income

This graph appears in the textbook as Figure 3-5.

Source: U.S. Department of Labor
www.bea.gov > National Economic Accounts >Interactive Table Home >Table Selection >
Table 1.10 (Gross Domestic Income by Type of Income) and Table 1.12 (National Income by Type of Income)

Ratio 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 0.738967838444278 0.736905623944002 0.73062318516864 0.727196123867706 0.725156494522692 0.718654434250765 0.723957481602616 0.732613723978412 0.738554726017749 0.749351323300467 0.762069391282874 0.752254823610001 0.74968982630273 0.749930664694463 0.75511069641191 0.740443126852863 0.739218422889044 0.732774674115457 0.73218201754386 0.734352791256188 0.735831360814613 0.7221318306282 0.720057016392213 0.7119124230554 0.705213567839196 0.70946959668167 0.717950877192982 0.717854518736223 0.714420449324079 0.714223803658593 0.718780387665579 0.721195595175668 0.726004118434995 0.724692724635468 0.717001093836857 0.710918303367169 0.703704890712134 0.698924409024179 0.709020847742318 0.711425002657596 0.719311107521404 0.722958431069088 0.721975425330813 0.721670699441442 0.711344917370742 0.699144994656217 0.691680774105218 0.700469006348527 0.70484585346251 0.699410468220833 0.68055425122299

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:

where A represents the level of technology.

CHAPTER 3 National Income

The Cobb-Douglas production function
Each factor’s marginal product is proportional to its average product:

CHAPTER 3 National Income

These formulas can be derived with basic calculus and algebra.

Labor productivity and wages
Theory: wages depend on labor productivity
U.S. data:
period productivity growth real wage growth
1960-2013 2.1% 1.8%
1960-1973 2.9% 2.7%
1973-1995 1.5% 1.2%
1995-2013 2.3% 2.0%

CHAPTER 3 National Income

The table shows the average annual rates of productivity and real wage growth in each time period. While not equal, the two series are very highly correlated.

Source: U.S. Department of Labor

The growing gap between rich & poor
Gini coefficient
Inequality has been rising in recent decades.

CHAPTER 3 National Income
This slide and the one that follows corresponds to new material in the 9th edition.

The Gini coefficient is a popular measure of inequality. A value of 0 would mean perfect equality, while a value of 1 would mean that one person has all the income.

Source: Same as the textbook.

Gini 17168 17533 17899 18264 18629 18994 19360 19725 20090 20455 20821 21186 21551 21916 22282 22647 23012 23377 23743 24108 24473 24838 25204 25569 25934 26299 26665 27030 27395 27760 28126 28491 28856 29221 29587 29952 30317 30682 31048 314 13 31778 32143 32509 32874 33239 33604 33970 34335 34700 35065 35431 35796 36161 36526 36892 37257 37622 37987 38353 38718 39083 39448 39814 40179 40544 40909 0.376 0.371 0.378 0.379 0.363 0.368 0.359 0.371 0.363 0.358 0.351 0.354 0.361 0.364 0.374 0.362 0.362 0.361 0.356 0.349 0.358 0.348 0.349 0.353 0.355 0.359 0.356 0.355 0.357 0.358 0.363 0.363 0.365 0.365 0.369 0.38 0.382 0.383 0.389 0.392 0.393 0.395 0.401 0.396 0.397 0.404 0.429 0.426 0.421 0.425 0.429 0.43 0.429 0.433 0.435 0.434 0.436 0.438 0.44 0.444 0.432 0.438 0.443 0.44 0.45 0.451

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 Goldin & 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.

CHAPTER 3 National Income

We’ve now completed the supply side of the model.

Demand for goods and 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

“g&s” is short for “goods & services”

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.

CHAPTER 3 National Income

The consumption function

C
Y – T

C (Y –T )

MPC
The slope of the consumption function is the MPC.

CHAPTER 3 National Income

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

CHAPTER 3 National Income

The investment function

r
I
I (r )

Spending on investment goods
depends negatively on the real interest rate.

CHAPTER 3 National Income

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:

CHAPTER 3 National Income

It might be useful to remind students of the meaning of the terms exogenous and transfer payments.

The market for goods & services
Aggregate demand:

Aggregate supply:

Equilibrium:

The real interest rate adjusts
to equate demand with supply.

CHAPTER 3 National Income

In the equation for the equilibrium condition, note that the real interest rate is the only variable that doesn’t have a “bar” over it—it’s the only endogenous variable in the equation, and it adjusts to equate the demand and supply in the goods market.

When the full slide is showing, before you advance to the next one, you might want to note that the interest rate is important in financial markets as well, so we will next develop a simple model of the financial system.

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

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

Loanable funds demand curve

r
I
I (r )

The investment curve is also the demand curve for loanable funds.

CHAPTER 3 National Income

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 and 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

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

CHAPTER 3 National Income

After showing definition of private saving,
– give the interpretation of the equation: Private saving is disposable income minus consumption spending
– explain why private saving is part of the supply of loanable funds:
Suppose a person earns $50,000/year, pays $10,000 in taxes, and spends $35,000 on goods and services. There’s $5000 remaining. What happens to that $5000? The person might use it to buy stocks or bonds, or he/she might put it in his/her savings account or money market deposit account. In all of these cases, this $5000 becomes part of the supply of loanable funds in the financial system.

After displaying public saving, explain the equation’s interpretation: public saving is tax revenue minus government spending.

Notice the analogy to private saving—both concepts represent income less spending: for the private household, income is (Y-T) and spending is C. For the government, income is T and spending is G.

Notation: Δ = change in a variable
For any variable X, ΔX = “change in X ”
Δ is the Greek (uppercase) letter Delta
Examples:
If ΔL = 1 and ΔK = 0, then ΔY = MPL.
More generally, if ΔK = 0, then

Δ(Y − T ) = ΔY − ΔT , so
ΔC = MPC × (ΔY − ΔT )
= MPC ΔY − MPC ΔT

CHAPTER 3 National Income

The Delta notation will be used throughout the text, so it would be very helpful if your students started getting accustomed to it now.

If your students have taken a semester of calculus, tell them that ΔX is (practically) the same thing as dX (if ΔX is small). Furthermore, some basic rules from calculus apply here with Δs:
The derivative of a sum is the sum of the derivatives:
Δ(X+Y) = ΔX + ΔY
The product rule:
ΔXY = (ΔX)(Y) + (X)(ΔY)

In fact, you can derive the two arithmetic tricks for working with percentage changes presented in Chapter 2.
Just take the preceding expression for the product rule and divide through by XY to get (ΔXY)/XY = ΔX/X + ΔY/Y, the first of the two arithmetic tricks.

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

CHAPTER 3 National Income
This problem reinforces the concepts with concrete numerical examples. It’s also a good way to break up the lecture and get students actively involved with the material.

ANSWERS
Calculate the change in saving

CHAPTER 3 National Income
First, in the box at the top of the slide, we plug the given value for the MPC into the expression for ΔS and simplify.
Then, finding the answers is straightforward: just plug in the given values into the expression for ΔS.

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 deficit by issuing Treasury bonds–i.e., borrowing. CHAPTER 3 National Income U.S. federal government surplus/deficit, 1940-2016 Percent of GDP CHAPTER 3 National Income (2012-2016 are estimates) Notes: 1. The huge deficit in the early 1940s was due to WW2. Wars are expensive. 2. The budget is close to balanced in the ’50s and ’60s, and begins a downward trend in the ’70s. 3. The early ’80s saw the largest deficits (as % of GDP) of the post-WW2 era, due to the Reagan tax cuts, defense buildup, and growth in entitlement program outlays. 4. The budget begins a positive trend in the early 1990s, and a surplus emerges in the late 1990s. There are several possible explanations for the improvement. First, President Bush (the first one) broke his campaign promise not to raise taxes. Second, the Clinton administration barely squeaked a deficit reduction deal through Congress (with Al Gore casting the tie-breaking vote in the Senate). And third, and probably most important, there was a swelling of tax revenues due to the surge in economic growth and the stock market boom. (A stock market boom leads to large capital gains, which leads to large revenues from the capital gains tax.) 5. The budget swings to deficit again in 2001, due to the Bush tax cuts and a recession. 6. Recently, the budget deficit in current dollars has reached all-time highs, due to a sharp fall in tax receipts, the enactment of multibillion dollar bailouts and a large stimulus package. Data source: http://www.gpoaccess.gov/usbudget/fy11/hist.html Budget of the United States Government: Historical Tables Fiscal Year 2011, Table 1.2 Surplus or Deficit (−) 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 0.8 -0.6 -4 -4.5 -5.9 -4 -5.5 -2.5 -0.1 -3.2 -3 -4.3 -14.2 -30.3 -22.7 -21.5 -7.2 1.7 4.6 0.2 -1.1 1.9 -0.4 -1.7 -0.3 -0.8 0.9 0.8 -0.6 -2.6 0.1 -0.6 -1.3 -0.8 -0.9 -0.2 -0.5 -1.1 -2.9 0.3 -0.3 -2.1 -2 -1.1 -0.4 -3.4 -4.2 -2.7 -2.7 -1.6 -2.7 -2.6 -4 -6 -4.8 -5.1 -5 -3.2 -3.1 -2.8 -3.9 -4.5 -4.7 -3.9 -2.9 -2.2 -1.4 -0.3 0.8 1.4 2.4 1.3 -1.5 -3.4 -3.5 -2.6 -1.9 -1.2 -3.2 -10 -8.9 -10.9 -7 -4.6 -3.6 -3.2 -3.3 U.S. federal government debt, 1940-2016 Percent of GDP CHAPTER 3 National Income (2012-2016 are estimates) A later chapter will give more details, but for now, tell students that the government finances its deficits by borrowing from the public. (This borrowing takes the form of selling treasury bonds). Persistent deficits over time imply persistent borrowing, which causes the debt to increase. After WW2, occasional budget surpluses allowed the government to retire some of its WW2 debt; also, normal economic growth increased the denominator of the debt-to-GDP ratio. Starting in the early 1980s, corresponding to the beginning of huge and persistent deficits, we see a huge increase in the debt ratio, from 32% in 1981 to 66% in 1995. In the mid 1990s, budget surpluses and rapid growth started to reduce the debt ratio, but it started rising again in 2001 due to the economic slowdown, the Bush tax cuts, and higher spending (Afghanistan and Iraq, war on terrorism, 2002 airline bailout, etc.). The recent financial crisis/recession has increased the debt ratio, as revenues have fallen while outlays (the stimulus package, bailouts) have sharply increased. Source: http://www.gpoaccess.gov/usbudget/fy11/hist.html Budget of the United States Government: Historical Tables Fiscal Year 2011, Table 7.1 Gross Federal Debt 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 52.4 50.4 54.9 79.1 97.6 117.5 121.7 110.3 98.2 93.1 94.1 79.7 74.3 71.4 71.8 69.3 63.9 60.4 60.8 58.6 56 55.2 53.4 51.8 49.3 46.9 43.5 42 42.5 38.6 37.6 37.8 37.1 35.6 33.6 34.7 36.2 35.8 35 33.2 33.4 32.5 35.3 39.9 40.7 43.8 48.2 50.4 51.9 53.1 55.9 60.7 64.1 66.1 66.6 67 67.1 65.4 63.2 60.9 57.3 56.4 58.8 61.6 62.9 63.5 63.9 64.4 69.4 84.2 93.2 102.6 105.3 106 105.5 105.2 105.2 Loanable funds supply curve r S, I National saving does not depend on r, so the supply curve is vertical. CHAPTER 3 National Income At the end of this chapter, we will briefly consider how things would be different if consumption (and therefore saving) were allowed to depend on the interest rate. For now, though, they do not. Loanable funds market equilibrium r S, I I (r ) Equilibrium real interest rate Equilibrium level of investment CHAPTER 3 National Income 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, Eq’m in L.F. market Eq’m in goods market CHAPTER 3 National Income This slide establishes that we can use the loanable funds supply/demand diagram to see how the interest rate that clears the goods market is determined. Explain that the symbol  means each one implies the other. The thing on the left implies the thing on the right, and vice versa. More shorthand: “eq’m” is short for “equilibrium” and “L.F.” for “loanable funds.” 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 This is good general advice for students. They will learn many models in this course. Many exams include questions requiring students to show how some event shifts a curve, and then use the model to analyze its effect on the endogenous variables. If students methodically follow the steps presented on this slide for each model they learn in this course (and other economics courses), they will likely do better on the exams and get more out of the course. 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 CHAPTER 3 National Income Continuing from the previous slide, let’s look at all the things that affect the S curve. Then, we will pick one of those things and use the model to analyze its effects on the endogenous variables. Then, we’ll do the same for the I curve. 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: CHAPTER 3 National Income CASE STUDY: The Reagan Deficits r S, I I (r ) r1 I1 r2 2. …which causes the real interest rate to rise… I2 3. …which reduces the level of investment. 1. The increase in the deficit reduces saving… CHAPTER 3 National Income Are the data consistent with these results? 1970s 1980s T – G –2.2 –3.9 S 19.6 17.4 r 1.1 6.3 I 19.9 19.4 T–G, S, and I are expressed as a percent of GDP All figures are averages over the decade shown. CHAPTER 3 National Income Display the data line by line, noting that it matches the model’s predictions—except for investment. The model says that investment should have fallen as much as savings. Ask students why they think it didn’t. Answer: In our closed economy model of Chapter 3, the only source of loanable funds is national saving. But the U.S. is actually an open economy. In the face of a fall in national saving (i.e., the domestic supply of loanable funds), firms can finance their investment spending by importing foreign loanable funds. More on this in an upcoming chapter. 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? CHAPTER 3 National Income Students may be confused because we are (somehow) changing taxes, but assuming T is unchanged. Taxes have different effects. The total amount of taxes (T ) affects disposable income. But even if we hold total taxes constant, a change in the structure or composition of taxes can have effects. Here, by holding total taxes constant, we ensure that neither disposable income nor public saving change, yet the composition of taxes changes to give consumers an incentive to increase their saving. Answer: The vertical S curve shifts right, causing the interest rate to fall and investment to rise. These effects are exactly the opposite as pictured in the “Reagan deficits” case study a few slides earlier. Mastering the loanable funds model (continued) 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 CHAPTER 3 National Income An increase in investment demand An increase in desired investment… r S, I I1 I2 r1 r2 …raises the interest rate. But the equilibrium level of investment cannot increase because the supply of loanable funds is fixed. CHAPTER 3 National Income 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 Suggestion: Display these questions and give your students 3-4 minutes, working in pairs, to try to find the answers. Then display the analysis on the next slide. Reasons why saving might depend on r: An increase in r makes saving more attractive and increases the reward for postponing consumption. Many consumers finance their spending on big-ticket items like cars and furniture, and an increase in r makes such borrowing more expensive. However, an increase in r might also reduce saving through the income effect: A higher interest rate 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 saving will fall. It is usually assumed that the substitution effect is at least as great as the income effect, so that an increase in the interest rate will either increase saving or leave saving unchanged. An increase in investment demand when saving depends on r r S, I I(r) I(r)2 r1 r2 An increase in investment demand raises r, which induces an increase in the quantity of saving, which allows I to increase. I1 I2 CHAPTER 3 National Income CHAPTER SUMMARY Total output is determined by: the economy’s quantities of capital and labor the level of technology Competitive firms hire each factor until its marginal product equals its price. If the production function has constant returns to scale, then labor income plus capital income equals total income (output). CHAPTER 3 National Income CHAPTER SUMMARY A closed economy’s output is used for consumption, investment, and government spending. The real interest rate adjusts to equate the demand for and supply of: goods and services. loanable funds. CHAPTER 3 National Income CHAPTER SUMMARY A decrease in national saving causes the interest rate to rise and investment to fall. An increase in investment demand causes the interest rate to rise but does not affect the equilibrium level of investment if the supply of loanable funds is fixed. CHAPTER 3 National Income (,) FKLKL = (,)()() FzKzLzKzL = zKL = 2 zKL = 2 zKL = (,) zFKL = (,) FKLKL =+ 22 (,)()() FzKzLzKzL =+ 22 (,) zFKL = 2 ( ) zKL =+ 222 (,) K FKL L = 2 (,) FKLKL =+ () (,) zK FzKzL zL = 2 zK zL = 22 K z L = 2 (,) zFKL = (,) FzKzLzKzL =+ () zKL =+ and KKLL == , = () YFKL Chart1 0 1 2 3 4 5 6 7 8 9 10 Labor (L) Output (Y) Production function 0 10 19 27 34 40 45 49 52 54 55 Sheet1 chap3ppt-MPL example.xls L Y MPL 0 0 1 10 10 2 19 9 3 27 8 4 34 7 5 40 6 6 45 5 7 49 4 8 52 3 9 54 2 10 55 1 Sheet1 Labor (L) Output (Y) Production function Sheet2 Labor (L) Units of output (MPL) Marginal Product of Labor (MPL) Sheet3 FKL (,) a) 215 FKLKL =+ (,) FKLKL = (,) b) c) 215 FKLKL =+ (,) L K W L P MPLL =´ R K P MPKK =´ YMPLLMPKK =´+´ 1 YAKL - = aa 11 Y MPKAKL K -- == aa a a (1) (1) Y MPLAKL L - - =-= aa a a and GGTT == -++ ()() CYTIrG = (,) YFKL -++ = ()() YCYTIrG Y MPL L D = D . S D YCG =D-D-D 0.8() YYTG =D-D-D-D 0.20.8 YTG =D+D-D 1 . 0 a 0 S D=- 0.800 b. 108 S D=´= 0.200 c. 102 S D=´= MPL201020, d. 0 YL D=´D=´= 0.20.220040. SY D=´D=´= () SYCYTG =--- Û GS Þ¯ TCS ¯ÞÞ¯ 1 S 2 S S () Sr /docProps/thumbnail.jpeg

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