Lecture 3 - Chapter 3 (Part 2) Macroeconomics

Macroeconomics N. Gregory Mankiw National Income: Where it Comes From and Where It Goes Presentation Slides © 2022 Worth Publishers, all rights reserved  IN THIS CHAPTER, YOU WILL LEARN: What...

Macroeconomics N. Gregory Mankiw National Income: Where it Comes From and Where It Goes Presentation Slides © 2022 Worth Publishers, all rights reserved  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 National Income Income Outline of model (2 of 2) A closed economy, market-clearing model Demand for goods and services A closed economy has three (3) uses for the goods and services it produces. These three (3) components of GDP are expressed in the national income accounts identity: Y=C+I+G C = consumer demand for goods and services I = demand for investment goods/gross private domestic investment G = government demand for goods and services (closed economy: no NX ) Consumption, C Disposable income is total income minus total taxes: Y – T ie. after tax income Where T = Taxes Transfer Payments Consumption function: C = C (Y – T ) This notation simply means that consumption depends on disposable income. An example of a consumption function is  C = a + b(Y − T),where a and b are parameters. Definition: marginal propensity to consume (MPC) is the change in C when disposable income increases by one dollar. For example, if the MPC is 0.8, then households spend $0.80 of each additional dollar of disposable income on consumer goods and services and save $0.30. (an extra dollar of income increases consumption but by less than one dollar) The Consumption Function 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 – if the firm wants to build a factory, borrow from an institution  the opportunity cost of using one’s own funds to finance investment spending So, I depends negatively on r – an inverse relationship  Here r is the real interest rate, not the rental rate of capital (R)  If the nominal interest rate is 7% and the inflation rate is 3%, then the real interest rate is 4%. NB the real interest rate measures the true cost of borrowing and, thus, determines the quantity of investment. The investment function Government spending, G G = government spending on goods and services G excludes transfer payments (for example, Social Security benefits, unemployment insurance benefits) Assume that government spending and total taxes are exogenous: G = G and T = T Equilibrium in the Market for Goods and Services: The Supply and Demand for the Economy’s Output The following equations summarize the demand and supply of goods and services for the economy: Since Y=C+I+G The real interest rate C=C(Y−T) adjusts to equate demand I=I(r) with supply G= T= determine the quantity of Y = F (, ) = output supplied to the economy – Aggregate supply Using these equations and noting that G and T are fixed by policy and Y is fixed by the factors of production and the production function, we can derive the following relationship (We combine these equations describing the supply and demand for output and substitute into the national income accounts identity): - Equilibrium condition – supply = demand, what the real interest rate should be to ensure equilibrium The Loanable Funds Market A simple supply–demand model of the financial system. One asset: “loanable funds”  demand for funds: investment – businesses and consumers, primarily businesses  supply of funds: saving – households, government sector  “price” of funds: real interest rate Supply and Demand Of Loanable Funds The supply of loanable funds comes from saving:  Households use their saving to make bank deposits and 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. Investment is the demand for loanable funds:  Investors borrow from the public through bonds or banks, and the quantity of loanable funds demanded is influenced by the interest rate. The interest rate adjusts based on the balance between investment and savings. A low rate increases the demand for the economy's output by investors than households want to save, while a high rate decreases it, as households save more than firms invest (the quantity of loanable funds demanded exceeds the quantity supplied). The equilibrium interest rate is reached at these intersections. Equilibrium in the Financial Markets: The Supply and Demand for Loanable Funds We can rewrite the equilibrium condition as Y−C−G=I national saving or put simply savings (S) Split national saving into two parts: S=(Y−T−C)+(T−G)=I. OR Private Public saving Saving We show how the interest rate brings financial markets into equilibrium by Y−C(Y−T)−G=I(r) NB. note that G and T are fixed by policy, and Y is fixed by the factors of production and the production unction −C(− )− I(r) I(r) Combining the saving terms into national saving, S, we obtain I(r) Demand for funds: Investment The demand for loanable funds: comes from investment: Firms borrow to finance spending on plant and equipment, new office buildings, etc. Consumers borrow to buy new houses. depends negatively on r: r is the “price” of loanable funds (cost of borrowing). Loanable funds demand curve 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 Changes in Saving: The Effects of Fiscal Policy -An Increase In Government Purchases ΔG – Suppose that the government carries out an expansionary fiscal policy by increasing spending or cutting taxes. The increase in government purchases must be met by an equal decrease in investment, therefore, interest rates must rise, causing the crowding out effect. Expressed in terms of the loans market, there is less saving available, so there will be less investment in equilibrium. Changes in Saving: The Effects of Fiscal Policy -An Increase in Government Purchases Changes in Saving: The Effects of Fiscal Policy – A Decrease In Taxes ΔT – the impact is to raise disposable income, therefore, raising consumption. Consumption rises by an amount equal to ΔT times the marginal propensity to consume MPC. The higher the MPC, the greater the impact of the tax cut on consumption C = I Because the tax cut raises disposable income by ΔT, consumption goes up by MPC×ΔT. S falls by the same amount as consumption rises. 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—that is, borrowing.  Loanable funds supply curve National saving S = Y  C(Y  T )  G does not depend on r, so the supply curve is vertical. Loanable Funds Market Equilibrium The Special Role of r r adjusts to equilibrate the goods market and the loanable funds market simultaneously: If the loanable funds market is in equilibrium, then Y–C–G=I Add (C +G ) to both sides to get Y = C + I + G (goods market equilibrium) Thus, Eq'm in L.F. market  Eq'm in goods market 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. Mastering the loanable funds model (1 of 2) 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 Mastering the Loanable Funds Model (2 of 2) 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 example: investment tax credit  An Increase In Investment Demand Investment Demand increases from I1 to I2: Results in an increase in r. No change in equilibrium investment. 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?  An Increase In Investment Demand When Saving Depends On R Investment Demand increases From I1 to I2: Results in an increase in r and an increase in equilibrium investment.  C HAP TER SUMMARY, PAR T 1 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 National Income Income  C HAP TER SUMMARY, PAR T 2 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 National Income Income  C HAP TER SUMMARY, PAR T 3 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 National Income Income