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## Chapter 3: National Income

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### ... purposes, whereas high interest rates discourage borrowing ... Public saving: left over government revenue: Sg = T G. Determination of Real Interest Rate ... – PowerPoint PPT presentation

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Title: Chapter 3: National Income

1
Chapter 3 National Income
2
Production Function
• Output of goods and services as a function of
factor inputs
• Y F(K, L)
• Y product output
• K capital input
• L Labor input

3
Constant Returns to Scale
• When an increase in the quantity of the inputs
results in an equal increase in the quantity of
the output
• F(zK, zL) zY
• where z gt 0

4
Supply of Products
• Because we assume that the supplies of capital
and labor inputs and the production technology
are fixed, the supply of product output is also
fixed
• Y F(K, L) Y

5
Input Price Determination
• Input or factor prices are determined by the
supply and demand for them.
• Because we assume the input supply is fixed, its
supply line is vertical. The factor demand curve
is downward sloping.
• The intersection of demand and supply determines
the factor price.

6
Input Price Determination
Price
Supply
Equilibrium price
Demand
Quantity
7
Profit Determination
• Profit Revenue Labor Cost Capital Cost
• ? PY WL RK
• P price of output
• W price of labor input wage rate
• R price of capital input interest rate

8
Production Function
Labor in the variable input
Output
F(K,L)
MPL
1
MPL
1
MPL
1
Labor
9
Marginal Product of Inputs
• Additional productivity gained from hiring an
extra unit of the labor input. MPL and MPK are
• MPL F(K, L1) F(K, L)
• MPK F(K1, L) F(K, L)

10
Diminishing Marginal Product of Labor
• As more labor input is added, holding
capital input constant, the quantity of output
will increase at a decreasing rate. Hence, MPL
declines, due to inefficiency, as more labor is

Units of output
MPL
Units of labor
11
The Firms Demand for Labor
• Demand for labor depends on its price and
marginal product
• In a competitive market MPL W/P the real
wage. The labor demand is
• W P ? MPL

12
The Firms Demand for Capital
• Demand for capital depends on its price and
marginal product
• In a competitive market MPK R/P the real
interest. The capital demand is
• R P ? MPK

13
Diminishing Marginal Product of Capital
• As more capital input is added, holding
labor input constant, the output will increase at
a decreasing rate. Hence, MPK declines, due to
inefficiency, as more capital is added.

Units of output
MPK
Units of capital
14
Determinants of Demand for Products
• The GDP for a closed economy is total spending by
households, firms, and government
• Y C I G
• Consumption C
• Investment I
• Government purchases G

15
The Circular Flow on Income and Product
Income Payments
Labor Market
Labor Resources
Saving
Investment
Financial Market
Households
Firms
Government
Taxes
Government Purchases
Products
Product Market
Consumption Expenditures
16
Consumption Function
• Consumption is a function of disposable personal
income
• C C(Y T)
• Y personal income
• T personal income taxes

17
Consumption Function
• Marginal propensity to consume additional
consumption from an extra dollar of disposable
personal income
• MPC ?C / ?(Y T)
• MPC is slope of consumption function.

18
Consumption Function
Consumption, C
C C(Y T)
MPC
1
Disposable income, Y - T
19
Investment Function
• Investment is a negative function of the real
interest rate
• I I(r)
• Low interest rates encourage borrowing for
investment purposes, whereas high interest rates
discourage borrowing

20
Investment Function
Real interest rate, r
I(r)
Quantity of investment, I
21
Government Role
• We assume government purchases of goods and
services and resources and personal income taxes
are fixed amounts
• G G
• T T

22
National Income Identity
• Y C I G, where
• C C(Y T)
• I I(r)
• G G and T T
• Y C(Y T) I(r) G

23
Saving Investment Identity
• Equilibrium in the product market
• Y C(Y T) I(r) G
• Y - C(Y T) - G I(r)
• S I(r)
• Where S is national saving

24
Components of National Saving
• Private saving left over household income
• Sp Y T C
• Public saving left over government revenue
• Sg T G

25
Determination of Real Interest Rate
Real interest rate
S
Equilibrium interest rate
I(r)
Investment, Saving
26
Increase in Investment Demand
Real interest rate
An increase in investment demand results in a
higher interest rate.
S
r2
r1
I(r)
I(r)
Investment, Saving
27
Classical Saving Function
• Saving is positively related to the real interest
rate S S(r)

Real interest rate
S(r)
Quantity of Saving
28
Increase in Investment Demand
Real interest rate
S(r)
r2
r1
I2
I1
Quantity of Saving
I2
I1