Ch. 3 - National Income: Where It Comes From and Where It Goes

Question 1

Let’s update our circular flow diagram to include firms, households, markets for goods and services, markets for factors of production, financial markets and governments. Let’s look at the flow of dollars from the viewpoint of these economic actors. Households:

Answer 1

Households receive income and use it to
-pay taxes to the government
-consume goods and services
-save through financial markets
Both households and firms borrow in financial markets to buy investment goods, such as housing, and factories.

Question 2

Let’s update our circular flow diagram to include firms, households, markets for goods and services, markets for factors of production, financial markets and governments. Let’s look at the flow of dollars from the viewpoint of these economic actors. Firms:

Answer 2

Firms receive revenue from the sale of goods and services and use it to pay for the factors of production.
Both households and firms borrow in financial markets to buy investment goods, such as housing, and factories.

Question 3

Let’s update our circular flow diagram to include firms, households, markets for goods and services, markets for factors of production, financial markets and governments. Let’s look at the flow of dollars from the viewpoint of these economic actors. Government:

Answer 3

The government receives revenue from taxes, uses it to pay for government purchases.

Question 4

What is public saving?

Answer 4

Any excess of tax revenue over government spending. Budget surplus if positive, budget deficit if negative.

Question 5

What does an economy’s output of goods and services - its GDP - depend on? (2)

Answer 5

• Its quantity of inputs, called factors of production

- Its ability to turn inputs into outputs, as represented by the production function.

Question 6

What are factors of production?

Answer 6

The inputs used to produce goods and services.

Question 7

What are the 2 most important factors of production?

Answer 7

• Labor

- Capital

Question 8

What is capital?

Answer 8

The set of tools that workers use. K

Question 9

What is labor?

Answer 9

The time people spend working. L

Question 10

What do we write if K or L is fixed?

Answer 10

K or L with an overbar. (line on top) the

Question 11

What do we assume in our model for now?

Answer 11

That factors of production are fully utilized - that is, that no resources are wasted.

Question 12

What determined how much output is produced from given amounts of capital and labor?

Answer 12

The available production technology.

Question 13

Which equation states that output if a function of the amount of capital and the amount of labor?

Answer 13

Y = F(K,L)

Question 14

What does the production function reflect?

Answer 14

The available technology for turning capital and labor into output.

Question 15

What is it that alters the production function?

Answer 15

Technological change.

Question 16

When does a production function have constant returns to scale?

Answer 16

When an increase of an equal percentage in all factors of production causes an increase in output of the same percentage.
zY = F(zK,zL)

Question 17

Why is it that factors of production and the production function determine nation income?

Answer 17

Because the factors of production and the production function together determine the total output of goods and services.

Question 18

What is the neoclassical theory of distribution based on?

Answer 18

It’s based on the (18th century) idea that prices adjust to balance supply and demand (applied here to the markets for the factors of production) together with the more recent (19th century) idea that the demand for each factor of production depends on the marginal productivity of that factor.

Question 19

In this model, what is the distribution of national income determined by?

Answer 19

Factor Prices

Question 20

What are factor prices?

Answer 20

The amounts paid to the factors of production - the wage workers earn and the rent the owners of capital collect.

Question 21

What is the rental price each factor of production receives for its services determined by?

Answer 21

The supply and demand for that factor.

Question 22

What are properties of a competitive firm?

Answer 22

A competitive firm is small relative tot he markets in which it trades, so it has little influence on market prices.

Question 23

What is Y, K, L P, W, and R?

Answer 23

Y = Total Output
K = Capital stock
L = Work force
P = Price
W = Wage
R = Rental rate of capital

Question 24

What is the goal of a firm?

Answer 24

To maximize profit.

Question 25

What is profit?

Answer 25

Profit = Revenue - Labor Costs - Capital Costs
Profit = PY - WL - RK
Profit = PF(K,L) - WL - RK

Question 26

What does the equation Profit = PF(K,L) - WL - RK show in general?

Answer 26

That profit depends on the product price P, The factor prices W and R, and the factor quantities L and K.

Question 27

What does the equation Profit = PF(K,L) - WL - RK say about how competitive firms operate?

Answer 27

The competitive firm takes the product price and the factor prices as given and chooses the amounts of labor and capital that maximize profit.

Question 28

What property do most production functions have?

Answer 28

Diminishing marginal product.

Question 29

What is diminishing marginal product of labor?

Answer 29

Holding the amount of capital fixed, the marginal product of labor decreases as the amount of labor increases.

Question 30

What is the marginal product of labor graphically for a production function which holds K constant?

Answer 30

MPL = Slope of this production function

Question 31

The increase in revenue from an additional unit of labor depends on which 2 variables?

Answer 31

• MPL

- Price of output

Question 32

How does the increase in revenue from an additional unit of labor depends on MPL and Price of output?

Answer 32

Because an extra unit of labor produces MPL units of output and each unit of output sells for P dollars, the extra revenue is PXMPL.

Question 33

Where does the increase in cost from an additional unit of labor come from?

Answer 33

The extra cost of hiring one more unit of labor is the wage W.

Question 34

How does profit change from one additional unit of labor?

Answer 34

change in profit = change in revenue - change in cost

change in profit = (PXMPL) - W

Question 35

How much labor does a firm hire?

Answer 35

The firm’s management knows that if the extra revenue PXMPL exceeds the wage W, an extra unit of labor increases profit. Therefor, the manager continues to hire labor until the next unit would no longer be profitable - that is, until the MPL falls to the point where the extra revenue equals the wage.

Question 36

What is the competitive firm’s demand for labor determined by?

Answer 36

PXMPL = W
equivalently
MPL = W/P
where W/P is the real wage

Question 37

What is a real wage?

Answer 37

The payment to labor measured in units of output rather than in dollars.

Question 38

How do competitive firms hire labor?

Answer 38

To maximize profit, the firm hires up tot he point at which the marginal product of labor equals the real wage.

Question 39

What does the MPL depend on?

Answer 39

The amount of labor employed.

Question 40

How does a figure graphing units of output per units of labor look like?

Answer 40

The figure graphs the MPL schedule. Because the MPL diminishes as the amount of labor increases, the curve slopes downward. For any given real wage, the firm hires up tot he point at which the MPL equals the real wage. Hence, the MPL schedule is also the firm’s labor demand curve.

Question 41

What is the marginal product of labor?

Answer 41

The extra amount of output the firm gets from one extra unit of labor, holding the amount of capital fixed.

Question 42

What is the marginal product of capital?

Answer 42

The extra amount of output the firm gets from one extra unit of capital, holding the amount of labor fixed.

Question 43

What is MPK?

Answer 43

MPK = F(K+1,L) - F(K,L)

Question 44

What is MPL?

Answer 44

MPL = F(K,L+1) - F(K,L)

Question 45

What is diminishing marginal product of capital?

Answer 45

Holding the amount of labor fixed, the marginal product of capital decreases as the amount of capital increases.

Question 46

How does profit change from one additional unit of capital?

Answer 46

change in profit = change in revenue - change in cost

change in profit = (PXMPK) - R

Question 47

How much capital does a firm rent?

Answer 47

The firm’s management knows that if the extra revenue PXMPK exceeds the rental rate R, an extra unit of capital increases profit. Therefore, the manager continues to rent capital until the next unit would no longer be profitable - that is, until the MPK falls to the point where the extra revenue equals the rental rate of cpaital.

Question 48

What is the competitive firm’s demand for capital determined by?

Answer 48

MPK = R/P

where R/P is the real rental price of capital.

Question 49

What is the real rental price of capital?

Answer 49

The rental price measured in units of goods produced rather than in dollars.

Question 50

To sum up the competitive, profit maximizing firm follows a simple rule about how much labor and how much capital to rent. What is it?

Answer 50

The firm demands each factor of production until that factor’s marginal product falls to equal its real factor price.

Question 51

Having analyzed how a firm decides how much of each factor to employ, explain how the markets for the factors of production distribute the economy’s total income if all firms in the economy are competitive and profit-maximizing.

Answer 51

Each factor of production is paid its marginal contribution to the production process. The real wage paid to each worker equals the MPL, and the real rental price paid to each owner of capital equals the MPK. The total real wages paid to labor are therefore MPLxL, and the total real return paid to capital owners is MPKxK

Question 52

What is economic profit?

Answer 52

The income that remains after the firms have paid the factors of production.

Question 53

What’ the real economic profit equation?

Answer 53

Economic profit = Y - (MPLxL) - (MPKxK)

Y = (MPKxL) + (MPKxK) + Economic Profit

Question 54

How is total income divided among the economy?

Answer 54

Total income is divided among the return to labor, the return to capital, and economic profit.

Question 55

How large is economic profit in an economy?

Answer 55

If the production function has the property of constant returns to scale, then economic profit must be zero. Thai is, nothing is left after the factors of production are paid.

Question 56

The conclusion that there is 0 economic profit comes from Euler’s theorem. What does it state about the production function with constant returns to scale?

Answer 56

F(K,L) = (MPKxK) + (MPLxL)
If each factor is paid its marginal product, the the summ of these factor payments equal total output. In other words, constant returns to scale, profit maximization, and competition together imply that economic profit is zero.

Question 57

If economic profit is zero, how can we explain the existence of “profit” in the economy?

Answer 57

The term “Profit” as normally used is different from economic profit. We’ve been assuming that there are three types of agents: workers, owners of capital, and owners of firms. Total income is divided among wages and return to capital, and economic profit. In the real world however, most firms own rather than rent the capital they use. Because firm owners and capital owners are the same people, economic profit and the return to capital are often lumped together.

Question 58

In the real world, most firms own rather than rent the capital they use. Because firm owners and capital owners are the same people, economic profit and the return to capital are often lumped together. If we call this alternative definition accounting profit, what is accounting profit?

Answer 58

Accounting profit = Economic profit + (MPKxK)

Question 59

Under our assumptions - constant returns to scale, profit maximization, and competition - economic profit is zero. If these assumptions approximately describe the world, where does the “profit” in the national income accounts come from?

Answer 59

The “profit” in the national income accounts must mostly return to capital.

Question 60

Give a Grand Summation of how the income of the economy is distributed from firms to households.

Answer 60

Each factor of productions is paid its marginal product, and these factor payments exhaust total output. Total output is divided between the payments to capital and the payments to labor, depending on their marginal productivities.

Question 61

According to the neoclassical theory of distribution, why does a change in the quantity of any one factor alter the marginal product of all the factors?

Answer 61

According to the neoclassical theory of distribution, factor prices equal the marginal product of the factors of production. Therefore, a change in the quantity of any one factor alter the marginal product of all the factors because the marginal product depends on the quantities of the factors. Therefore, a change in the supply of a factor alters the equilibrium prices.

Question 62

The outbreak of the bubonic plague in 1348 reduced the population of Europe by about one-third within a few years. Describe how fourteenth-century Europe provides a vivid example of how factor quantities affect factor prices.

Answer 62

Because the marginal product of labor increases as the amount of labor falls, this massive reduction in the labor force raised the marginal product of labor. Real wages did increase substantially during the plague years. The peasants who were fortunate enough to survive he plague enjoyed economic prosperity.

Question 63

How did the reduction in the labor force caused by the plague also affect the other major factor of production?

Answer 63

The reduction in the labor force also affected the return to land. With fewer workers available to farm the land, an additional unit of land produced less additional output. This fall in marginal product of land let to a decline in real rents. Thus, while the peasant class prospered, the landed classes suffered reduced incomes.

Question 64

What production function describes how actual economies turn capital and labor into GDP?

Answer 64

Cobb-Douglass Production Function

Question 65

What surprising fact did Paul Douglas notice when he was still a professor of economics?

Answer 65

That the division of national income between capital and labor has been roughly constant over a long period. In other words, as the economy grew more prosperous over time, the total income of worker and the total income of capital owners grew at almost exactly the same rate.

Question 66

What did Paul Douglas’ observation cause him to wonder?

Answer 66

What conditions lead to constant factor shares.

Question 67

What did Paul Douglas ask Charles Cobb?

Answer 67

What production function, if any, would produce constant factor shares if factors always earned their marginal products.

Question 68

Which 2 properties would a production function that produced constant factor shares if factors always earned their marginal products have to have?

Answer 68

Capital Income = MPKxK = αY
Labor income = MPLxL = (1-α)Y
where a is a constant between zero and one that measures capital’s share of income. That is, α determines what share of income goes to capital and what share goes to labor.

Question 69

Which equation did Cobb show had the required properties desired by Douglas?

Answer 69

Y = F(K,L) = Ak^(α)L^(1-α)

where A is a parameter greater than 0 that measures the productivity of the available technology.

Question 70

What is the first important property of the Cobb-Douglas production function?

Answer 70

It has constant returns to scale. That is, if capital and labor are increased by the same proportion, then output increases by that proportion as well.

Question 71

Consider the marginal products for the Cobb-Douglas production function.
MPL = (1-α)AK^αL^(-α)
MPK = αAK^(α-1)L^(1-α)
Explain how we can see what causes the marginal products of the two factors to change, recalling that α is between 1 and 0.

Answer 71

An increase in the amount of capital raises the MPL and reduces the MPK. Similarly, an increase in the amount of labor reduces the MPL and raises the MPK. A technological advance that increases the parameter A raises the marginal product of both factors proportionately.

Question 72

How can the marginal products for the Cobb-Douglas production function also be written as?

Answer 72

MPL = (1-α)Y/L
MPK = αY/K

Question 73

What does our new way of writing the marginal products for the Cobb-Douglas production function as
MPL = (1-α)Y/L
MPK = αY/K
show about output relative to capital and labor?

Answer 73

The MPL is proportional to output per worker and the MPK is proportional to output per unit of capital.

Question 74

What is Y/L?

Answer 74

Average labor productivity

Question 75

What is Y/K?

Answer 75

Average capital productivity

Question 76

What does our new way of writing the marginal products for the Cobb-Douglas production function as
MPL = (1-α)Y/L
MPK = αY/K
show about productivity?

Answer 76

If the production function is Cobb-Douglas, then the marginal productivity of a factor is proportional to its average productivity.

Question 77

How can we now verify that if factors earn their marginal products, then the parameter α indeed tells us how much total income goes to labor and how much goes to capital?

Answer 77

The total wage bill, which we have seen is MPLxL, equals (1-α)Y. Therefore, (1-α) is labor’s share out output. Similarly, the total return to capital, MPKxK, is αY, and α is capital’s share out output. The ration of labor income to capital income is a constant (1-α)/α. The factor shares depends only on the parameter α, not on the amoutns of capital or labor or on the state of technology as measured by parameter A.

Question 78

How does the neo-classical suggest that workers should enjoy a rapidly rising living stantards when labor productivity is growing robustly?

Answer 78

Because the neo-classical theory of distribution tells us that the real wage W/P equals the MPL, and the Cobb-Douglass production function tells us that the MPL is proportional to average labor productivity Y/L.

Question 79

Provide the simplest description of the aggregate consumption behavior of all households.

Answer 79

Households receive income from their labor and their ownership of capital, pay taxes to the government, and then decide how much of their after-tax income to consume and how much to save.

Question 80

What is disposable income?

Answer 80

Income after the payment of all taxes: Y - T

Question 81

How do households divide their disposable income?

Answer 81

Between consumption and saving.

Question 82

What do we assume about consumption here?

Answer 82

That the level of consumption depends directly on the level of disposable income. The higher is disposable income, the greater is consumption. Thus,
C = C(Y-T)

Question 83

What does the equation C = C(Y-T) state?

Answer 83

That consumption is a fraction of disposable income.

Question 84

What is the relationship between consumption and disposable income called?

Answer 84

The consumption function.

Question 85

What is MPC?

Answer 85

The marginal propensity to consume (MPC) is the amount by which consumption changes when disposable income increases by one dollar.

Question 86

What are the possible values of MPC?

Answer 86

The MPC is between 0 and 1: an extra dollar of income increases consumption, but by less than one dollar.

Question 87

What does it mean for households to have a MPC of 0.7?

Answer 87

Households spend 70 cents of each additional dollar of disposable income on consumer goods and services and save 30 cents.

Question 88

How can we find the MPC graphically?

Answer 88

The MPC is the slope of the consumption function.

Question 89

How do both firms and households buy investment goods?

Answer 89

Firms buy investment goods to add to their stock of capital and to replace existing capital as it wears out. Households buy new houses, which are also a part of investment.

Question 90

The quantity of investment goods demanded depends on many things. give some examples. (4)

Answer 90

• The rate of increase in new knowledge.
• The expectations firms have about the likelihood that households are ready to spend.
• The level of taxes.
• The interest rate.

Question 91

Why does the interest rate matter in determining the quantity of investment goods demanded?

Answer 91

The interest rate matters since it measures the cost of the funds used to finance investment. For an investment to be profitable, its return (the revenue from increased future production of goods and services) must exceed its cost (the payments for the borrowed funds). If the interest rate rises, fewer investments are profitable, and the quantity of investment goods demanded falls.
A person wanting to buy a new house faces a similar decision. The higher the interest rate, the greater the cost of carrying a mortgage.

Question 92

Throughout this book, we will talk about “the”interest rate, as if there were only one interest rate. The only distinction we will make is between the nominal interest (which is not corrected for inflation) and real interest (which is). The newspaper report so many interest rates. When you see two different interest rates, you can almost always eplain the difference by considering 3 things. In which 3 ways do the various reported interest rates differ?

Answer 92

-Term
-Credit Risk
Currency Denomination

Question 93

Some loans in the economy are for short periods of time. Others are for 30 years or even longer. How does the interest rate on a loan depend on its term?

Answer 93

Long-term interest rates are usually, but not always, higher than short-term interest rates.

Question 94

In deciding whether to make a loan, a lender must take into account the probability that the borrower will repay. The law allows borrowers to default on their loans by declaring bankruptcy. How does credit risk affect the interest rate?

Answer 94

The higher the perceived probability of default, the higher the interest rate. The safest credit risk is the government, and so government bonds tend to pay a low interest rate. At the other extreme, financially shaky companies can raise funds only by issuing junk bonds, which pay a high interest rate to compensate for the high risk of default.

Question 95

How does currency denomination affect credit risk?

Answer 95

A lender must be concerned about possible changes in international exchange rates. For example, an American who lends money to a provincial government by buying a bond denominated in CAD will for expectations concerning the likely change in the value of the CAD over the period he is making this loan. If the CAD is expected to fall in value, Canadian borrowers have to pay a higher interest rate than do borrowers in the US. Thus, the spread between Canadian and American interest rates widens whenever the Canadian dollar is perceived as “weak”.

Question 96

Although there are many different domestic interest rates, why do macroeconomists usually ignore these distinctions?

Answer 96

The various interest rates tend to move up and down together, For many purposes, it is acceptable to assume that there is only one interest rate.

Question 97

What are nominal interest rates?

Answer 97

The interest rate as usually reported: it’s the rate of interest investors pay to borrow money.

Question 98

What are real interest rates?

Answer 98

The nominal interest rate corrected for the effects of inflation.

Question 99

What do assume here about interest rates?

Answer 99

We assume here that the real interest rate measures the true cost of borrowing and, thus, determined the quantity of investment.

Question 100

Government spending are of which 2 types?

Answer 100

• Purchases of goods and services

- Transfer payments to households

Question 101

Why aren’t transfer payments included in the variable G?

Answer 101

Unlike government purchases, transfer payments are not made in exchange for some of the economy’s output of goods and services.

Question 102

How do transfer payments affect the demand for goods and services indirectly?

Answer 102

Transfer payments are the opposite of taxes: they increase households’ disposable income, just as taxes reduce disposable income. Thus, an increase in transfer payments financed by an increase in taxes leaves disposable income unchanged.

Question 103

How can we now revise our definition of T?

Answer 103

T is equal to taxes minus transfer payments. Disposable income, Y-T, includes both the negative impact of taxes and the positive impact of transfer payments.

Question 104

When does the government have a balanced budget?

Answer 104

When government purchases equal taxes minus transfers, then G = T.

Question 105

When does the government have a budget deficit?

Answer 105

When government purchases surpass taxes minus transfers, then G > T.

Question 106

When does the government have a budget surplus?

Answer 106

When government purchases are surpassed by taxes minus transfers, then G < T.

Question 107

What does it mean for here to take G as exogenous?

Answer 107

Here, we don’t try to explain the political process that leads to a particular fiscal policy - that is, to the level of government purchases and taxes.

Question 108

How do we denote G and T as exogenous.

Answer 108

By putting an overbar over the G and the T

Question 109

What are the endogenous variables here in our equation C + I + G

Answer 109

The endogenous variables here are consumption, investment, and the interest rate.

Question 110

What is the interest rate in the classical model?

Answer 110

The price that has the crucial role of equilibriating supply and demand.

Question 111

Which 2 ways can we think about the role of the interest rate in the economy?

Answer 111

• We can consider how the interest rate affects the supply and demand for goods and services.
• We can consider how the interest rate affects the supply and demand for loanable funds.

Question 112

Summarize this 
Y = C + I _ G
C = C(Y - T)
I = I(r)
G = G'
T = T'
where ' means overbar.

Answer 112

• The demand for the economy’s output comes from consumption, investment, and government purchases.
• Consumption depends on disposable income.
• Investment depends on the real interest rate.
• Government purchases and taxes are the exogenous variables set by fiscal policymakers.

Question 113

Earlier we saw that Y = F(K,L) = Y'. Now, combine this equation with our other equations 
Y = C + I _ G
C = C(Y - T)
I = I(r)
G = G'
T = T'

Answer 113

Y = C(Y - T) + I(r) + G
Because the variables G and T are fixed by policy, and the level of output Y is fixed by the factors of production and the production function, we can write
Y’ = C(Y’ - T’) + I(r) + G’
where ‘ means overbar.
Notice that r is the only variable not already determined.

Question 114

What does the equation
Y’ = C(Y’ - T’) + I(r) + G’
say?

Answer 114

That the supply of output equals its demand. which is the sum of consumption, investment, and government purchases.

Question 115

Notice that r is the only variable not already determined in the previous equation Y’ = C(Y’ - T’) + I(r) + G’. Why is this?

Answer 115

Because the interest rate still has a key role to play: it must adjust to ensure that the demand for goods equals the supply. The greater the interest rate, the lower the level of investment, and thus the lower the demand for goods and services, C + I + G.

Question 116

What happens if the interest rate is too high?

Answer 116

If the interest rate is too high, investment is too low, and the demand for output falls short of the supply.

Question 117

What happens if the interest rate if too low?

Answer 117

If the interest rate if too low, investment is too high, and the demand exceeds the supply.

Question 118

When is the interest rate in equilibrium?

Answer 118

At the equilibrium interest rate, the demand for goods and services equals the supply.

Question 119

Why can we better understand the role of the interest rate in the economy by thinking about the financial markets?

Answer 119

Because the interest rate is the cost of borrowing and the return to lending in financial markets.

Question 120

How can we better understand the role of the interest rate in the economy?

Answer 120

Rewrite the national accounts identity as Y - C - G = I

The term Y - C - G is the output that remains after the demands of consumers and the government have been satisfied.

Question 121

What is national savings?

Answer 121

Y - C - G

also called simply, savings (S)

Question 122

In this form, what does Y - C - G = I show?

Answer 122

That savings equals investment

S = I

Question 123

Which 2 parts can we split national savings into to better understand the identity S = I?

Answer 123

A part representing the saving of the private sector and a part representing the saving of the government.
(Y - T - C) + (T - G) = I
National saving is the sum of private and public saving.

Question 124

What is the term (Y - T - C)?

Answer 124

Private savings, which is disposable income minus consumption

Question 125

What is the term (T - G)?

Answer 125

Public saving, which is government revenue minus government spending.

Question 126

What is public savings when the government runs a deficit?

Answer 126

Negative

Question 127

What is public savings when the government runs a surplus?

Answer 127

Positive

Question 128

Which interpretation of the equation
(Y - T - C) + (T - G) = I
does the circular flow diagram mentioned earlier reveal?

Answer 128

This equation states that the flows into the financial markets (private and public saving) must balance the flows out of the financial markets (investment).

Question 129

What’s the first step to seeing how the interest rate brings financial markets into equilibrium?

Answer 129

Substitute the consumption function and the investment function into the national accounts identity:
Y - C(Y - T) - G = I(r)

Question 130

What’s the second step to seeing how the interest rate brings financial markets into equilibrium?

Answer 130

Note that G and T are fixed by public policy and Y is fixed by the factors of production and the production function:
Y’ - C(Y’ - T’) - G’ = I(r)
S’ = I(r)
The left-hand side of this equation shows that national savings depends on income Y and the fiscal policy variable G and T. For fixed values of Y, G, and T, national saving S is also fixed. The right hand side of the equation shows that investment depends on the interest rate.

Question 131

Why is the saving function graphed as a vertical line here?

Answer 131

Because in this model, saving doesn’t depend on the interest rate (we relax this assumption later).

Question 132

Why is the investment function graphed as an downward sloping curve?

Answer 132

The higher the interest rate, the fewer investment projects are profitable.

Question 133

How can we think of saving and investment as supply and demand?

Answer 133

In this case, the “good” is loanable funds, and its “price” is the interest rate.
Savings is the supply of loanable funds
Investment is the demand for loanable funds.

Question 134

How is saving the supply of loanable funds?

Answer 134

Households lend their saving to investors or deposit their saving in a bank that then loans the funds out.

Question 135

How is investment is the demand for loanable funds?

Answer 135

Investors borrow from the public directly by selling bonds or indirectly by borrowing from banks.

Question 136

What follows, in the financial markets, from the fact that investment depends on the interest rate

Answer 136

The quantity of loanable funds demanded also depend on the interest rate.

Question 137

How does the interest adjust to reach equilibrium?

Answer 137

The interest adjusts until the amount that firms want to invest equals the amount that households want to save.

Question 138

What happens in the financial markets if the interest is too low?

Answer 138

If interest is too low, investors want more of the economy’s output than households want to save. Equivalently, the quantity of loans demanded exceeds the quantity supplied. When this happens, the interest rate rises.

Question 139

What happens in the financial markets if the interest is too high?

Answer 139

If interest is too high , households want to save more of the economy’s output than households want to save more than firms want to invest. Because the quantity of loans supplied is greater than the quantity demanded, the interest rate falls..

Question 140

When is the financial market in equilibrium?

Answer 140

The equilibrium interest rate is found where the two curves cross. At the equilibrium interest rate, households’ desire to save balances firms’ desire to invest, and the quantity of loans supplied equals the quantity demanded.

Question 141

if we look within labor income, we find that that gap between the earnings of high-wage workers has grown substantially since the 1970’s. As a result, income inequality is greater today than it was four decades ago; the same pattern is found in many western countries. Although economists do not have a definitive answer to the question of what has caused this growing income disparity between rich and poor, what is one diagnosis presented by Claudia Goldin and Lawrence Katx in their book The Race Between Education and Technology?

Answer 141

Their bottom line is that “the sharp rise in inequality was largely due to an educational slowdown.”
According to them, for the past century, technological progress has been a steady force that has not only increased average living standards, but has also increased the demand for skilled workers relative to unskilled workers. Skilled workers are needed to apply and manage new technologies, while less skilled workers are more likely to become obsolete.

Question 142

Why did skilled workers not benefit disproportionately from economic growth in the analysis of the results of Goldin’s and Katz’s findings?

Answer 142

For much of the 20th century, skill-biased technological change was outpaced by advances in educational attainment. In other words, while technological progress increased the demand for skilled workers, our educational system increased the supply of them even faster. As a result, skilled workers did not benefit disproportionately from economic growth.

Question 143

Why are skilled workers starting to benefit disproportionately from economic growth in the analysis of the results of Goldin’s and Katz’s findings?

Answer 143

Recently things have changed. Over the last several decades, technological advance has kept up its pace, while educational advancement has slowed down. Because growth in the supply of skilled workers has slowed, their wages have grown relative to those of the unskilled.

Question 144

What are the implication of the analysis by Goldin and Katz for public policy?

Answer 144

The implication of this analysis for public policy is that reversing the rise in income inequality will likely require putting more of society’s resources into education (which economists call human capital).

Question 145

What are the implication of the analysis by Goldin and Katz for personal decision making?

Answer 145

The implication for personal decision making is that college and graduate school are investments well worth making.

Question 146

How can we use our model to show how fiscal policy affects the economy?

Answer 146

When the governments changes its spending or the level of taxes, it affects the demand for the economy;s output of goods and services and alters national saving, investment, and the equilibrium rate.

Question 147

Using our model to show how fiscal policy affects the economy, consider first the effects of an increase in government purchases by an amount ΔG. What is the immediate impact of the increase in government purchases?

Answer 147

The immediate impact is to increase the demand for goods and services by ΔG. But since total output is fixed by the factors of production, the increase in government purchases must be met by a decrease in some other category of demand. Since disposable income Y - T is unchanged, consumption C is unchanged as well. The increase in government purchases must be met by an equal decrease in investment.

Question 148

How can fiscal policy induce investment to fall?

Answer 148

To induce in vestment to fall, the interest rate must rise. Hence, the increase in government purchases causes the interest rate to increase and investment to decrease. Government purchases are said to crowd out investment .

Question 149

To grasp the effect of an increase in government purchases, consider the impact on the market for loanable funds.

Answer 149

Since the increase in government purchases is not accompanied by an increase in taxes, the government finances the additional spending by borrowing - that is, by reducing public saving. Since private saving is unchanged, this government borrowing reduces national saving.

Question 150

How is a reduction in national saving represented graphically?

Answer 150

A reduction in national saving is represented by a leftward shift in the (vertical) supply of loanable funds available for (downward sloping) investment. At the initial interest ate, the demand for loans exceeds the supply. The equilibrium interest rate rises to the point where the investment schedule crosses the new saving schedule.. Thus, an increase in government purchases causes the interest rate to rise.

Question 151

Why do wars provide a natural experiment with which economists can test their theories?

Answer 151

Because the economic changes accompanying them are often large we can learn about the economy by seeing how in wartime the endogenous variables respond to the major changes in the exogenous variables.

Question 152

What is one exogenous variable that changes substantially during wartime?

Answer 152

The level of Government Purchases.

Question 153

What does out model predict about the increase in government spending during wartime?

Answer 153

Our model predicts that this wartime increase in government purchases - and the increase in government borrowing to finance the wars - should have raised the demand for goods and services, reduces the supply of loanable funds, and raised the interest rate.

Question 154

How does the data on the interest rate on long-term government bonds, called consols in the UK, in wartime compare to the predictions made by our model?

Answer 154

A positive association between military purchases and interest rates is apparent in the data which supports the models prediction: interest rates do tend to rise when government purchases increase.

Question 155

What is one problem with using wars to test economic theories?

Answer 155

Many economic changes may be occurring at the same time. Economic models predict what happens when one exogenous variable changes and all the other exogenous variables remain constant. In the real world, however, many exogenous variables may change at once.

Question 156

Give 2 examples how other changing exogenous variables could have had an impact during WWII.

Answer 156

In WWII, while government purchases increased dramatically, rationing also restricted consumption of many goods.
In addition, the risk of defeat in the war and default by the government on this debt presumably increased the interest rate the government must pay.

Question 157

Using our model to show how fiscal policy affects the economy, consider a reduction in taxes ΔT. What is the immediate impact of the tax cut?

Answer 157

The immediate impact of the tax cut is to raise disposable income and thus to raise consumption. Disposable income rises by ΔT, and 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.

Question 158

Why must the increase in consumption caused by a reduction in taxes be met by a decrease in investment?

Answer 158

Since the economy is fixed by the factors of production and the level of government purchases is fixed by the government, the increase in consumption must be met by a decrease in investment. For investment to fall, the interest rate must rise. Hence, a reduction in taxes, like an increase in government spending, crowds out investment and raises the interest rate.

Question 159

Analyze the effect of a tax cut by looking at saving and investment.

Answer 159

Since the tax cut raises disposable income by ΔT, consumption goes up by MPCxΔT. National saving s, which equals Y - C - G, falls by the same amount as consumption rises. The reduction in saving shifts the supply of loanable funds to the left, which increases the equilibrium interest rate and crowds out investment.

Question 160

One of the most dramatic economic events in recent history was the large change in fiscal policies of most Western countries in the latter three decades of the twentieth century. How was fiscal policy before these changes?

Answer 160

Before this period, all governments had run deficits during numerous short intervals of time. But governments had often run surpluses as well, so that, over the long-run, there was not a large increase in their national debts.

Question 161

One of the most dramatic economic events in recent history was the large change in fiscal policies of most Western countries in the latter three decades of the twentieth century. How was fiscal policy after these changes?

Answer 161

Starting in the mid-1970’s, the excess of government spending over tax revenues increased by a wide margin, and this gas became a permanent fixture of fiscal policy. It was not until the mid-1990’s that deficits were worked down.

Question 162

One of the most dramatic economic events in recent history was the large change in fiscal policies of most Western countries in the latter three decades of the twentieth century. How do the results of this action relate to our predictions?

Answer 162

As our model predicts, this change in fiscal policy led to higher world interest rates and lower levels of saving.

Question 163

We can use our model to examine how how changes affect investment. One reason why investment might increase is technological innovation. How would technological innovation cause investment to rise?

Answer 163

Suppose that someone invents a new technology, such as the railroad or computer. Before a firm or household can take advantage of the innovation, it must buy investment goods. The invention of the railroad had no value until railroad cars were produced and tracks were laid. The idea of the computer was not productive until computers were manufactured. Thus, technological innovation leads to an increase in investment demand.

Question 164

We can use our model to examine how how changes affect investment. One reason why investment might change is because the government encourages or discourages investment through tax laws. How would the government use tax laws to increase the demand for investment goods?

Answer 164

For example. suppose that the government increases personal income taxes and uses the extra revenue to provide tax cuts for those who invest in new capital. Such a change in the tax laws makes more investment projects profitable and, like a technological innovation, increases the demand for investment goods.

Question 165

What is the graphical effect of an increase in investment demand?

Answer 165

At any given interest rate, the demand for investment goods (and also for loans) is higher, This increase in demand is represented by a shift in the investment schedule to the right. The economy moves from the old Eq. to the new Eq.

Question 166

What is the surprising implication of the graphical effect of an increase in investment demand?

Answer 166

That the equilibrium amount of investment is unchanged. Under our assumptions, the fixed supply of saving determines the amount of investment; in other words, there is a fixed supply of loans. An increase in investment demand merely raises the equilibrium interest rate.

Question 167

The surprising implication of the graphical effect of an increase in investment demand was that the equilibrium amount of investment is unchanged. How would we reach a different conclusion, however, if we modified our simple consumption function?

Answer 167

We would we reach a different conclusion if we modified our simple consumption function and allowed consumption (and its flip side, saving) to depend on the interest rate. Because the interest rate is the return to saving (as well as the cost of borrowing), a higher saving schedule would be upward sloping rather than vertical.

Question 168

How would we reach a different conclusion about investment changes not increasing investment if we modified our simple consumption function to allow consumption to depend on the interest rate?

Answer 168

With an upward-sloping saving schedule, an increase in investment demand would raise both the equilibrium interest rate and the equilibrium quantity of investment. The increase in the interest rate causes households to consume less and save more. The decrease in consumption frees resources for investment.

Question 169

In this chapter we have developed a model that explains the production, distribution, and allocation of the economy’s output of goods and services. Because the model incorporates all the interactions illustrated in the circular flow diagrams in the beginning, what is it sometimes called?

Answer 169

The General Equilibrium Model.

Question 170

Summarize the General Equilibrium Model.

Answer 170

The model emphasizes how prices adjust to equilibrate the supply and demand. Factor prices equilibrate factor markets. The interest rate equilibrates the supply and deman for goods and services (or, equivalently, the supply and demand for loanable funds).

Question 171

In our model, investment depends on the interest rate. Economists who look at economic data, however, usually fail to find an obvious association between investment and interest rates. Should we discard our model? Luckily, we do not have to discard our model. Why is that?

Answer 171

The inability to find an empirical relationship between investment and interest rates is an example of the identification problem.

Question 172

What is the identification problem?

Answer 172

The identification problem arises when variables are related in more than one way. When we look at data, we are observing a combination of these different relationships, and it is difficult to “identify” any one of them.