MACROECONOMICS
cover art ROW 1 (90)
C H A P T E R
© 2008 Worth Publishers, all rights reserved
SIXTH EDITION
PowerPoint® Slides by Ron Cronovich
N. GREGORY MANKIW
National Income:
Where it Comes From
and Where it Goes
3

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.
New to the 6^th edition, the appendix on the Cobb-Douglas production function is now integrated
into the chapter – and into this PowerPoint presentation.
Also, if you used the previous edition of these PowerPoints, you will find that I have cleaned up
and expanded the returns to scale section and the optional last section on the loanable funds model
with an upward-sloping saving curve.
As a result of these changes, this PowerPoint presentation is longer.  I suggest you look through
it before presenting it in class to determine whether there’s any material you might want to cut
out or shorten.

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CHAPTER 3   National Income
CHAPTER 3   National Income
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

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CHAPTER 3   National Income
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

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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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
Factors of production
§K  = capital:
tools, machines, and structures used in production
§L  = labor:
the physical and mental efforts of workers

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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 macro, 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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
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

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CHAPTER 3   National Income
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 = 1.25, then all inputs are increased by 25%)
§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

This material has been improved and expanded from the previous edition of these PowerPoints.
However, it is longer:  7 slides instead of 2.  To shorten your presentation, you might consider
omitting one or two of the following three examples, and/or eliminating one of the two “now you
try” in-class exercises.

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CHAPTER 3   National Income
CHAPTER 3   National Income
Example 1
constant returns to scale for any z > 0

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CHAPTER 3   National Income
CHAPTER 3   National Income
Example 2
decreasing returns to scale for any z > 1

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CHAPTER 3   National Income
CHAPTER 3   National Income
Example 3
increasing returns to scale for any
z > 1

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CHAPTER 3   National Income
CHAPTER 3   National Income
Now you try…
§Determine whether constant, decreasing, or increasing returns to scale for each of these
production functions:
§ (a)
§ (b)

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CHAPTER 3   National Income
CHAPTER 3   National Income
Answer to part (a)
constant returns to scale for any z > 0

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CHAPTER 3   National Income
CHAPTER 3   National Income
Answer to part (b)
constant returns to scale for any z > 0

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CHAPTER 3   National Income
CHAPTER 3   National Income
Assumptions of the model
1.Technology is fixed.
2.The economy’s supplies of capital and labor are fixed at

Emphasize that “K” and “L” (without bars on top) are variables - they can take on various
magnitudes.  On the other hand, “Kbar” and “Lbar” are specific values of these variables.  Hence,
“K = Kbar” means that the variable K equals the specific amount Kbar.
Regarding the assumptions:
In chapters 7 and 8 (the Economic Growth chapters), 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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
Determining GDP
§Output is determined by the fixed factor supplies and the fixed state of technology:

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

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CHAPTER 3   National Income
CHAPTER 3   National Income
The distribution of national income
§determined by factor prices,
the prices per unit that firms pay for the
factors of production
§wage = price of L
§rental rate = price of K
§

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

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CHAPTER 3   National Income
CHAPTER 3   National Income
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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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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
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?

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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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
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

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CHAPTER 3   National Income
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)

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CHAPTER 3   National Income
CHAPTER 3   National Income
Exercise:  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 ?

This exercise is 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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
Answers:

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CHAPTER 3   National Income
CHAPTER 3   National Income
Diminishing marginal returns
§As a factor input is increased,
its marginal product falls (other things equal).
§Intuition:
Suppose L while holding K fixed
§Þ fewer machines per worker
§Þ lower worker productivity

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Tell class:  Many production functions have this property.
This slide introduces some short-hand notation that will appear throughout the PowerPoint
presentations of the remaining chapters:
•The up and down arrows mean increase and decrease, respectively.
•The symbol “” means “causes” or “leads to.”
Hence, the text after “Intuition” should be read as follows:
   “An increase in labor while holding capital fixed causes there to be fewer machines per worker,
which causes lower productivity.”
Many instructors use this type of short-hand (or something very similar), and it’s much easier and
quicker for students to write down in their notes.

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CHAPTER 3   National Income
CHAPTER 3   National Income
Y
output
MPL and the production function
L
labor
1
MPL
1
MPL
1
MPL
As more labor is added, MPL ¯
Slope of the production function equals MPL

(Figure 3-3 on p.51)
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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
Check your understanding:
§Which of these production functions have diminishing marginal returns to labor?

Answers:
(a) does NOT have diminishing MPL.  MPL = 15, regardless of the value of L.
(b) and (c) both feature diminishing MPL
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.
  - finally, 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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
Exercise (part 2)
§Suppose W/P = 6.
d.If L = 3, should firm hire more or less labor?  Why?
e.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

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 7^th 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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
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

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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
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

The labor supply curve is vertical:  We are assuming that the economy has a fixed quantity of
labor, Lbar, regardless of 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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
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
§The 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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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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
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

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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
The Neoclassical Theory
of Distribution
§states that each factor input is paid its marginal product
§is accepted by most economists

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When I teach this theory, after saying “accepted by most economists” I append “at least, as a
starting point.”  This theory is fine for macro models with only one type of labor.  But taken
literally, it implies that people who earn low wages have low marginal products.  Thus, this theory
would attribute the entire observed wage gap between white males and minorities to productivity
differences, a conclusion that most would find objectionable.

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CHAPTER 3   National Income
CHAPTER 3   National Income
How income is distributed:
§total labor income  =
If production function has constant returns to scale, then
total capital income  =
labor
income
capital
income
national
income

The last equation follows from Euler’s theorem, discussed in text on p. 54.

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CHAPTER 3   National Income
CHAPTER 3   National Income
The ratio of labor income to total income in the U.S.
Labor’s share of total income
Labor’s share of income
 is approximately constant over time.
(Hence, capital’s share is, too.)

This graph appears in the textbook as Figure 3-5 on p.57.
This and the next two slides cover the Cobb-Douglas production function.  In the textbook’s
previous edition, this material was covered in an appendix.
Source:  www.bea.gov

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CHAPTER 3   National Income
CHAPTER 3   National Income
The Cobb-Douglas Production Function
§The Cobb-Douglas production function has constant factor shares:
§ a = capital’s share of total income:
§capital income  =  MPK x K  =  a Y
§labor income  =  MPL x L  =  (1 – a )Y
§The Cobb-Douglas production function is:
§
where A represents the level of technology.

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CHAPTER 3   National Income
CHAPTER 3   National Income
The Cobb-Douglas Production Function
§Each factor’s marginal product is proportional to its average product:

These formulas can be derived with basic calculus and algebra.

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CHAPTER 3   National Income
CHAPTER 3   National Income
Outline of model
§A closed economy, market-clearing model
§Supply side
qfactor markets (supply, demand, price)
qdetermination of output/income
§Demand side
qdeterminants of C, I, and G
§Equilibrium
qgoods market
qloanable funds market
DONE  ü
DONE ü
Next è

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

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CHAPTER 3   National Income
CHAPTER 3   National Income
Demand for goods & 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 )

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“g & s” is short for “goods & services”

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CHAPTER 3   National Income
CHAPTER 3   National Income
Consumption, C
§def:  Disposable income is total income minus total taxes:    Y – T.
§Consumption function:  C = C (Y – T )
§ Shows that (Y – T ) Þ C
§def:  Marginal propensity to consume (MPC) is the increase in C  caused by a one-unit increase in
disposable income.

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Again, we are using the short-hand notation that will appear throughout the remaining PowerPoints:
        X   Y    means  “an increase in X causes a decrease in Y.”
Please feel free to edit slides if you wish to substitute other notation.

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CHAPTER 3   National Income
CHAPTER 3   National Income
The consumption function
C
Y – T
C (Y –T )
1
MPC
The slope of the consumption function is the MPC.

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CHAPTER 3   National Income
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,  r  Þ ¯I

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CHAPTER 3   National Income
CHAPTER 3   National Income
The investment function
r
I
I (r )
Spending on investment goods
depends negatively on the real interest rate.

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CHAPTER 3   National Income
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:

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

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CHAPTER 3   National Income
CHAPTER 3   National Income
The market for goods & services
§Aggregate demand:
§Aggregate supply:
§Equilibrium:
§The real interest rate adjusts
to equate demand with supply.

Note the only variable in the equilibrium condition that doesn’t have a “bar” over it is the real
interest rate.
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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
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

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CHAPTER 3   National Income
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).

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CHAPTER 3   National Income
CHAPTER 3   National Income
Loanable funds demand curve
r
I
I (r )
The investment curve is also the demand curve for loanable funds.

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CHAPTER 3   National Income
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 to finance investment spending.
§The government may also contribute to saving
if it does not spend all the tax revenue it receives.

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CHAPTER 3   National Income
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

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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 she might put it in 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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
Notation:  D = change in a variable
§For any variable X,  DX  = “the change in X ”
§ D is the Greek (uppercase) letter Delta
Examples:
§If DL = 1 and DK = 0,  then DY = MPL.
More generally, if DK = 0, then
§D(Y-T ) = DY - DT , so
DC =    MPC ´ (DY - DT )
=   MPC DY  -  MPC DT

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 X is (practically) the same
thing as dX (if X is small).  Furthermore, some basic rules from calculus apply here with s:
•The derivative of a sum is the sum of the derivatives:
(X+Y) = X + Y
•The product rule:
XY = (X)(Y) + (X)(Y)
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 (XY)/XY =
X/X  + Y/Y, the first of the two arithmetic tricks.

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CHAPTER 3   National Income
CHAPTER 3   National Income
EXERCISE:
Calculate the change in saving
§Suppose  MPC = 0.8  and MPL = 20.
§For each of the following, compute DS :
§a. DG = 100
§b. DT = 100
§c. DY = 100
§d. DL =   10

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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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
Answers

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

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CHAPTER 3   National Income
CHAPTER 3   National Income
digression:
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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
U.S. Federal Government  Surplus/Deficit, 1940-2005

Notes:
1.  The huge deficit in the early 1940s was due to WW2:  wars are expensive.
2.  The budget is closed 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 has reached all-time highs, when measured in current dollars.  As
a percentage of GDP, though, the deficit does not seem quite as worrisome relative to the time
period captured in this graph.
Source of data:  U.S. Department of Commerce, Bureau of Economic Analysis.

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CHAPTER 3   National Income
CHAPTER 3   National Income
U.S. Federal Government Debt,
1940-2005
Fact:  In the early 1990s, about 18 cents of every tax dollar went to pay interest on the debt.
   (Today it’s about 9 cents.)

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-to-GDP ratio, from 32% in 1981 to 66% in 1995.  In the mid 1990s, budget surpluses and
rapid growth started to reduce the debt-to-GDP ratio, but it started rising again in 2001 due to
the economic slowdown, the Bush tax cuts, and higher spending (Afghanistan & Iraq, war on
terrorism, 2002 airline bailout, etc).
Students are typically shocked when they realize how much extra we are paying in taxes just to
service the debt; if it weren’t for the debt, we’d either pay much lower taxes, or have a lot of
revenue available for other purposes, like financial aid for college students, AIDS and cancer
research, national defense, Social Security reform, etc.
Source of data:  U.S. Dept of Commerce Bureau of Economic Analysis.

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CHAPTER 3   National Income
CHAPTER 3   National Income
Loanable funds supply curve
r
S, I
National saving does not depend on r,
so the supply curve is vertical.

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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
Loanable funds market equilibrium
r
S, I
I (r )
Equilibrium real interest rate
Equilibrium level of investment

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CHAPTER 3   National Income
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

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 short-hand:  “eq’m” is short for “equilibrium” and “LF” for “loanable funds.”

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CHAPTER 3   National Income
CHAPTER 3   National Income
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.

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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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
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

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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
CASE STUDY:
The Reagan deficits
§Reagan policies during early 1980s:
§increases in defense spending:  DG > 0
§big tax cuts:  DT < 0
§Both policies reduce national saving:

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CHAPTER 3   National Income
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…

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CHAPTER 3   National Income
CHAPTER 3   National Income
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.

Display the data line by line, noting that it matches the model’s predictions---UNTIL YOU GET TO
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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
Now you try…
§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?

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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.  In this problem, we’re holding total taxes constant, so disposable income does not
change, but we are changing the composition of taxes to give consumers an incentive to increase
their saving.

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CHAPTER 3   National Income
CHAPTER 3   National Income
Mastering the loanable funds model, continued
§Things that shift the investment curve
§some technological innovations
§to take advantage of the innovation,
firms must buy new investment goods
§tax laws that affect investment
§investment tax credit

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CHAPTER 3   National Income
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.

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CHAPTER 3   National Income
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?

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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.

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CHAPTER 3   National Income
CHAPTER 3   National Income
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 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
slide 66
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Chapter Summary
§A closed economy’s output is used for
§consumption
§investment
§government spending
§The real interest rate adjusts to equate
the demand for and supply of
§goods and services
§loanable funds
CHAPTER 3   National Income
slide 67
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>

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
slide 68
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