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NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES

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Macroeconomics ECO 403
VU
LESSON 07
NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
Key Questions to be addressed
·
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
Income
Factor payments
Markets for Factors of
Production
Financial Markets
Private
Savings
Govt.
Deficit
Taxes
Households
Firms
Government
Govt.
Purchases
Investments
Consumption
Firm revenues
Markets for Goods
and Services
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
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Macroeconomics ECO 403
VU
Equilibrium
·
goods market
·
loanable funds market
Factors of production
K = capital, tools, machines, and structures used in production
L = labor, the physical and mental efforts of workers
The production function
·
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 economy's level of technology.
·
exhibits constant returns to scale.
Assumptions of the model
Technology is fixed.
The economy's supplies of capital and labor are fixed at
K=K
and
L=L
Determining GDP
Output is determined by the fixed factor supplies and the fixed state
of technology:
Y = F (K, L)
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.
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
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Macroeconomics ECO 403
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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?
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)
def:
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)
Production Function
Production function
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Labor (L)
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Macroeconomics ECO 403
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Marginal Product of Labor
M arginal Product of Labor (M PL)
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Labor (L)
The MPL and the production function
Y
Output
F(K,L)
MPL
1
As more labor is
added, MPL ↓
MPL
1
Slope of the production
MPL
function equals MPL
1
L
Labor
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Macroeconomics ECO 403
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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
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
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 ↑
·
MPK curve is the firm's demand curve for renting capital.
·
Firms maximize profits by choosing K such that MPK = R/P .
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Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand