National Income: Where It Comes From and
Where It Goes
Chapter 3 of Macroeconomics, 9th 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!
What Determines the Total Production of Goods and
Services?
• Every theory starts with assumptions and then, step by step,
describes the conclusions that follow from the assumptions
• It is important to state the assumptions clearly
Two productive resources and one produced good
• There are two productive resources, capital and labor, whose
quantities are denoted K and L
• These two productive resources are used to produce one final
good, whose quantity is denoted Y
• As there is only one final good, Y can also be considered the
economy’s gross domestic product (as in Chapter 2)
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 = F(K, L)
– Example: Y = A·K0.3L0.7 Y = 5K0.3L0.7
labor
– A represents technology 0 10 20 30
– Y = 5K0.3L0.7, when A = 5 capital 0
1
0
0
0
25.06
0
40.71
0
54.07
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) = 5K0.3L0.7 labor
0 10 20 30
– Note: capital 0 0 0 0 0
1 0 25.06 40.71 54.07
• if you double both K and L, Y doubles 2 0 30.85 50.12 66.57
• if you triple both K and L, Y triples 3 0 34.84 56.60 75.18
4 0 37.98 61.70 81.95
• … and so on
– This feature of the Y = 5K0.3L0.7 production
function is called constant returns to scale It is common in economics
to assume that production
functions 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(z·K, z·L) = z·F(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 +
0.7 0.3 0.7
K L = z5K0.3L0.7 = z·F(K, L)
– Therefore, F(K, L) = 5K0.3L0.7 obeys constant returns to scale
GDP in the long run: assumptions
•
GDP in the long run
Predictions Grid
• GDP, Y
Capital, K +
Labor, L +
Technology, +
A
K, L, F(K, L) Y
GDP in the long run
• The first row of the predictions grid lists the Predictions Grid
GDP, Y
endogenous variables (unknowns)
Capital, K +
– In this case, Y is the only endogenous variable Labor, L +
• The first column lists the exogenous variables Technology, +
(knowns) A
– In this case, K, L, and A are the exogenous
Indicator Effect
variables
+ Endo moves in the same
• Each cell shows the kind of effect that the direction as exo
corresponding exogenous variable has on the – Endo moves in the opposite
direction as exo
corresponding endogenous variable
? Endo could move either way
0 Exo has no effect on endo
GDP in the long run: Exercise
Predictions Grid
• GDP, Y
Capital, K +
Labor, L +
Technology, +
A
Indicator Effect
+ Endo moves in the same
direction as exo
– Endo moves in the opposite
direction as exo
? Endo could move either way
0 Exo has no effect on endo
GDP in the long run
Predictions Grid
• Not only does the predictions grid show how the GDP, Y
listed exogenous variables affect some endogenous Capital, K +
variable, it lists all the exogenous variables that Labor, L +
Technology, +
affect an endogenous variable. A
– In this case, not only does the grid show that K, L, and A
have direct (+) effects on Y, they also imply that
– No other variable affects Y, according to our theory
• For example, although you may believe that government
spending, G, affects Y, our grid says that, according to our
theory, G has no effect on 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, all the capital
and labor that the economy has is fully utilized in production
– The idea is that capital and labor markets function well and ensure
the equality of supply and demand
• This assumption is not made in short-run theories, where it is
assumed tat some resources may remain unemployed
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?
– That is, 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.
• Assumption: Consumption expenditure is directly related to disposable
income Predictions Grid
Y C
Capital, K + +
Labor, L + +
Technology, A + +
Taxes, T −
The Consumption Function
C
C (Y –T )
The slope of the
MPC
consumption function
1 is the MPC.
Y–T
Marginal propensity to consume (MPC) is the The MPC is usually a positive
increase in consumption (C) when disposable fraction: 0 < MPC < 1.
income (Y – T) increases by one dollar I will denote it Cy
Consumption, C
• Assumption: Consumption expenditure is directly related to Predictions Grid
Y C
disposable income
Capital, K + +
• Consumption function: C = C (Y – T ) Labor, L + +
Technology, A + +
• Specifically, C = Co + Cy × (Y – T) Taxes, T −
Co +
• Co represents all other exogenous variables that affect
consumption, such as asset prices, consumer optimism,
interest rates, etc.
• Cy is the marginal propensity to consume (MPC), the fraction
of every additional dollar of disposable income that is
consumed
The Consumption Function
C C = Co2 + Cy∙(Y – T)
C = Co1 + Cy∙(Y – T)
Predictions Grid
Y C
+ +
Taxes, T −
Co +
T1 > T2
F(K, L) – T1 F(K, L) – T2 Y–T
Consumption shift factor: greater consumer optimism,
higher asset prices (Co↑)
Consumption, C
Predictions Grid
• Y C
Capital, K + +
Labor, L + +
Technology, A + +
Taxes, T −
Co +
Long-Run Consumption: Exercise
Predictions Grid
• Y C
Capital, K + +
Labor, L + +
Technology, A + +
Taxes, T −
Co +
Private-Sector Saving
•
Predictions Grid
Y C Y–T–C
K, L, A + + +
Taxes, T − −
Co + −
Private-Sector Saving
•
Predictions Grid
Y C Y–T–C
K, L, A + + +
Taxes, T − −
Co + −
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.
• Now, suppose C = 2 + 0.8✕(Y – T).
• Then, C = 2 + 0.8 ✕ 30 = 26 Private Saving is defined
as disposable income
minus consumption,
which is Y – T – C = 30 – 26
= 4.
K, L, F(K, L) Y
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 – C↑
• Similarly, Y↓⇒ C↓ and Y – C↓
Predictions Grid
Y C Y–C
K, L, A + + +
Taxes, T − +
Co + −
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
• National saving is denoted S and defined as the nation’s
income minus spending by consumers and the government:
• S=Y–C–G
National Saving: Predictions
Predictions Grid Predictions Grid
Y C Y–C Y C Y–C Y–C–G
K, L, Technology + + + K, L, Technology + + + +
Taxes, T − + Taxes, T − + +
Co + − Co + − −
Govt, G −
Predictions Grid
Y C S
K, L, Technology + + +
Taxes, T − +
Co + −
Govt, G −
National Saving = Investment
• In Chapter 2, we saw that Y = C + I + G + NX
• In this chapter, we study a closed economy. So: NX = 0.
Predictions Grid
• Therefore, Y = C + I + G
Y C S, I
• Y−C−G=I K, L, Technology + + +
Taxes, T − +
• Therefore, S = I C + −
o
Govt, G −
G
K, L, F(K, L) Y S=I=Y–C–G
C
C(Y – T), 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.
• Now, suppose C = 2 + 0.8✕(Y – T).
• Then, C = 2 + 0.8 ✕ 30 = 26 Public Saving = T – G
= 0.85 – 3 = –2.15
• 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
Y
C
C+G
I
C = Co + Cy(Y – T)
G
T
Y = F(K, L) Y–T
I = S = Y − C − G = Y − (C + G)
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 Real Interest Rate
• Example:
– Suppose that if you borrow a unit of the final good today, you’ll have
to repay 1.05 units of the final good a year from today.
– Then, the real interest rate is 0.05 units per unit borrowed.
– In percentage terms, the real interest rate is 5 percent.
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
Equilibrium in the Financial Markets: The Supply and
Demand for Loanable Funds
• To understand the long-run behavior of the real interest rate,
economists imagine a market for loanable funds
– The market for loanable funds is shorthand for all financial markets
• Borrowers provide the demand for loanable funds
• Lenders provide the supply of loanable funds
• The price of loanable funds is the real interest rate
• This real interest rate is assumed to automatically reach the
equilibrium level at which supply and demand are equal
Equilibrium in the Financial Markets: The Supply and
Demand for Loanable Funds
• Borrowers in the market for loanable funds are assumed to be
businesses who need money for their investment spending (I)
• Lenders are assumed to be lending their saving (S)
• In equilibrium, the real interest rate (r) equalizes supply and
demand
• That is, r ensures that S = I
Investment and the real interest rate
• Assumption: investment spending is inversely related to the
real interest rate
• I = I(r), such that r↑⇒ I↓
r
I (r )
I
Investment and the real interest rate
• Specifically, I = Io − Irr
• Here Ir is the effect of r on I and r
• Io represents all other factors that also
affect business investment spending Io2 − Irr
– such as business optimism, technological
Io1 − Irr
progress, etc.
I
The Real Interest Rate
•
I(r)
G r
K, L, F(K, L) Y S=I=Y–C–G
C
C(Y – T), T
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.
The Real Interest Rate: predictions
Predictions Grid
• Y C S, I r
K, L, Technology + + + −
Taxes, T − + −
Co + − +
Govt, G − +
Io +
The Real Interest Rate: Exercise
Predictions Grid
• Y C S, I r
K, L, Technology + + + −
Taxes, T − + −
Co + − +
Govt, G − +
Io +
The Real Interest Rate
S=Y–C–G Predictions Grid
r
S = F(K, L) – C(F(K, L) – T) – G Y C S, I r
K, L, Technology + + + −
r2 Taxes, T − + −
I(r) = Io2 − Irr Co + − +
r1
Govt, G − +
I(r) = Io1 − Irr
Io +
I(r)
G r
K, L, F(K, L) Y S=I=Y–C–G
C
C(Y – T), T
The Real Interest Rate: predictions
Predictions Grid
• Q: Why is it that business optimism or Y C S, I r
technological progress shifts the investment K, L, Technology + + + −
curve upwards, but does not affect the Taxes, T − + −
amount of investment in the long run? Co + − +
• Saving must equal investment Govt, G − +
• Business optimism does not affect saving Io +
r
• So, it can’t affect investment either S = F(K, L) – C(F(K, L) – T) – G
• Any increase in business optimism must be
cancelled out by an increase in the real r2
I = Io2 − Irr
interest rate r1
I = 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
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.
US Federal Government Budget
In fiscal year 2017 (October 1, 2016 -- September 30, 2017), the US federal government had $3,980,605 million in
net outlays and $3,314,894 million in receipts. The difference was a budget deficit of $665,712 million.
US Federal Government Budget
U.S. Federal Government Surplus/Deficit
Source: https://fred.stlouisfed.org/series/FYFSD
U.S. Federal Government Surplus/Deficit (% of GDP)
Source: https://fred.stlouisfed.org/series/FYFSDFYGDP
U.S. Federal Government Debt
U.S. Federal Government Debt (% of GDP)
Source: https://fred.stlouisfed.org/series/FYGFGDQ188S
CASE STUDY:
The Reagan deficits
Predictions Grid
• Reagan policies during early 1980s: Y C S, I r
K, L, A (Technology) + + + −
– increases in defense spending: ΔG > 0
Net Taxes, T − + −
– big tax cuts: ΔT < 0 Co + − +
• Both policies reduce national saving: Govt Spending, G − +
Io +
CASE STUDY:
The Reagan deficits
1. The increase in the r
deficit reduces
saving…
r2
2. …which causes the
real interest rate to
r1
rise…
3. …which reduces I (r )
the level of I2 I1 S, I
investment.
Are the data consistent with these results?
variable 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.
Whole chapter in one slide!
Predictions Grid
• Y C S, I r
K, L, A (Technology) + + + −
Net Taxes, T − + −
Co + − +
Govt Spending, G − +
Io +
Whole chapter in one slide!
Predictions Grid
• Y C S, I r
K, L, A + + + −
Net Taxes, T − + −
Co + − +
Govt, G − +
Io +
Note that every endogenous
variable has been expressed
entirely in terms of
exogenous variables.
