Chapter 3 - National Income Flashcards
(1) Basic Classical Model, traits and assumptions? (2) Supply side factors, and what they determine? (3) Demand side determines?
(1) traits: closed economy (no NX) market-clearing model; assumptions; Y determined by fixed factors (K, L, Tech)
(2) factor markets (supply, demand, price), determine output/income
(3) Demand determines C, I, G
Determinants of G&S production
factors of prod (based on technology avail): Capital and Labor
Production Function: (function, returns, assumptions)
production function: Y = F(K,L)
Constant returns to scale: cost per unit of output is constant
Assumptions: Tech, L, K fixed and maximized
Returns to scale (definition)
Returns to Scale: impact on output (Y), when scale all inputs by same factor (z) (LR property)
Returns to scale (steps and guidelines)
Steps:
Initially: Y1 = F(K1,L1)
Scaling: K2 = zK1 & L2 = zL1
Outcome: Y2 = F(K2,L2)
IRS: macro costs trend, micro profitability trends
Increasing returns to scale: Y2 > zY1
Macro: average cost decreasing
Micro: profitable at larger scale
DRS: macro costs trend, micro profitability trends
Decreasing returns to scale Y2 < zY1
Macro: average costs increase
Micro: profitable at smaller scale
CRS: macro costs trend and micro profitability trend
Constant returns to scale: Y2 = zY1
Macro: average cost constant
Micro: neither
Do returns to scale reflect the law of diminishing returns?
No, there is no diminishing returns because all inputs are the same (fixed). Diminishing returns apply when one input rises and all other are fixed.`
What determines total output and national income?
factors and production function
Circular flow diagram demonstrates?
national income flow from firms –> households through factor markets
Neoclassical theory of distribution (define, basis)
how national income is divided to factors of prod.
(1) Classical (18th cent.) idea that price adjust to balance markets, for the factors of prod
- Consider: since now know that supply is fixed, we only analyze demand
(2) Recent (19th cent.) idea that demand each factor depends on its marginal productivity
Distribution of national income determined by ____?
Factor prices
Factor prices and ex.
amounts paid to factors of production
EX. wage = price of L rental rate = price of K
Notation - what represents?
W, R, P, W/P, R/P
o W – nominal wage (firm hires workers at W, price of L),
o R – nominal rental rate (firm rents capital at R, price of K)
o P – price of output (firms sells output at P)
o W/P – real wage (measured in units of output)
o R/P – real rental rate
Nominal vs Real
nominal: current prices
Real: prices adjusted for inflation
What determines factor prices?
the market S and D (where S fixed) in factor markets. Prices reach EQ
Profit as a function of factor costs (K,L)
Profit = PF(K,L) = PY - WL - RK = revenue - labor cost - capital cost
PF(K,L) is ???
Profit = PF(K,L)
Profit = PY - WL - RK
Profit = revenue - labor cost - capital cost
Competitive firms use what 5 variables to max profit?
chooses amount of L and K to max profit using given P, W, R
*Y not a variable
MR = ? (demand for L)
MR = MPL*P (benefit of hiring one more)
MC = ? (demand for L)
MC = W (cost of hiring one more)
How many units labor competitive firm hire?
hire until point where
MC = MR
W = MPL*P
or
MPL = W/P (where W/P is real wage)
MPL = ? (formula)
MPL = F(K,L+1) – F(K,L)
MPL definition and graphical implication in G&S market and Labor market
Marginal Product of Labor: extra output firm prod. Using additional unit L (other inputs fixed)
represents:
G&S: slope of the production function
Labor market: demand for labor
What law is demonstrated through MPL ?
Law of Diminishing Marginal product
Law of diminishing marginal returns? What declines?
Law of Diminishing Marginal returns: as input rises (other constant), MPL will eventually fall
Decline in: machines per worker and productivity of workers (if using labor inputs rising)
EXAMPLE: If W/P =6, at what MPL will firm hire more, less, and optimal number of labor units
more: if MPL > 6
less: if MPL < 6
optimal: MPL = 6
Labor market EQ real wage = ?
when Supply fixed, find where S = MPL
*since MPL is labor demand
Determining rental rate (cost of capital inputs)
MPK = R/P
maximize profit by choosing K that makes equation true
MPK definition and represents graphically
Marginal Product of Capital: extra output firm prod. Using additional unit K (other inputs fixed)
represents:
Capital market: demand for renting capital
what is income divided/distributed to?
return to labor, capital and economic profit
how are factors paid (from income)?
in a competitive and profit maximizing firm, paid its marginal contribution to production processes
Economic profit
income remain after firm paid factors of production (for owners)
Real Economic Profit
Real Economic profit: economic profit includes implicit costs (opportunity cost)
Economic Profit = ? (equation)
Economic Profit = Y – (MPLL) – (MRKK)
EP = output - total paid to labor - total paid to capital
OR
Y = (MPLL) + (MRKK) + Economic Profit
MPLL = total paid to labor
MRKK =total paid to capital
Each factor earns?
according to its marginal product
When is economic profit =0
Constant returns to scale, profit max, perfect competition: imply LR
each factor paid MP, sum of pmts = total output
aka. F(K,L) = (MPKK) + (MPLL)
When firm owners are capital owners, what is lumped together
economic profit and return to capital
Cobb Douglas Production Function (definition)
production function with constant factor shares (sum of powers = 1)
Cobb Douglas Production Function Notation = ?
Notation: Y = AKalpha * L(1-alpha)
What does each represent?
Y = AK^alphaL^(1-alpha)
A – level of technology
alpha – capital’s share of total income
1-alpha – labor’s share of total income
What does each represent?
Y = A * K^alpha * L^(1-alpha)
Y - output
A – level of technology
K - capital
L - labor
alpha – capital’s share of total income
1-alpha – labor’s share of total income aka beta
Capital Income =? (formula)
Capital income = MPKK = alphaY
Cobb Douglas Production Function and returns to scale rules?
Sum of powers:
If alpha + beta
= 1 (constant RS),
>1 (increasing RS),
<1 (DRS)
In Cobb Douglas Production function, powers represent ___?
powers represent the shares of total income for units
Labor productivity growth has a +/- relationship with real wage growth?
What are LT and ST observations?
Labor productivity growth & real wage growth have POSITIVE relationship
productivity of labor determines wage growth
LT: wages set according to labor productivity (works well)
SR: wage and productivity growth can vary (things take time, does not work in SR)
Classical Model:
characteristics?
what consists of each demand, supply, and equilibrium (outlines entire chapter concepts)
characteristics: closed economy, market clearing
Supply side:
factor markets (S, D, P)
determination of output/income
Demand side:
determinants of C,G,I
Equilibrium:
goods market
loanable funds market
Components of Aggregate demand (G&S market) in basic model
C – Consumer demand for g&s
I – demand for investment goods
G – government demand for G&S
Note: closed economy tf: no NX
Consumption Function:
Functional form = ?
C = C(Y-T)
Consumption = ? (equation and represent variables)
C = a + b*(Y-T)
a - autonomous consumption (independent of income level), always +
b - Marginal Propensity to consume (MPC)
(Y-T) - Disposable income (income less tax)
Marginal Propensity to Consume (MPC)
(1) definition?
(2) graphical representation?
(3) nature of value?
definition: MPC is change in C when disposable income rises 1$ (aka how much of each additional dollar spent)
graph: slope of consumption function (aka b)
not linear IRL (poor/higher vs rich/low have different MPC)
value: between 0 and 1 (fraction)
Two ways express disposable income (equations)
Disposable income = (Y-T)
Disposable income = Spending + savings
EX. if b = 0.29, what is the increase in C for each %increase in disposable income?
EX. if b=0.6: C increases by 60% for every % increase in (Y-T)
*since b is slope of consumption function
Marginal Propensity to Save (MPS)? Definition? Equation? Nature of value?
MPS is change in Investment when disposable income rises 1$ (Fraction of $1 increase in disposable income that is saved)
MPS = 1 - MPC
value is always positive (unless debt?)
EXAMPLE:
if C = 50 + 0.8(Y-T)
Find MPC, MPS
If Y-T rises by 100, find:
change in S
Change in C
When income is 100, total consumption is __
^^what is induced consumption value?
MPC = 0.8 (b value)
MPS = 0.2 (1-b)
C increase by 80 (100.8)
S increase by 20 (100.2)
Total consumption is 130
aka C(100) = 130
Induced consumption: 80
Induced consumption definition
change in consumption due to the change in income (C*MPC)
Investment Function
Functional form - ?
describe variable(s)
I = I(r)
r - real interest rate aka cost borrowing
real interest rate
Alternate name?
Definition?
Opportunity cost?
Relationship with I?
Relationship with demand for I?
Alt name: cost of borrowing
Definition: nominal interest rate adjusted for inflation
OC of using own funds to finance investment spending
r negative relationship with I
r negatively determines demand for investment
Will an increase in r impact a
Yes!
r increases will reduce household consumption. cost of borrowing will fall
Government Spending functional form ?
Tax functional form(s)?
G = Gbar
T = Tbar (not proportional to income, lump sum)
T = t*Y (tax is proportional)
t - tax rate
Aggregate Demand Equation =?
Aggregate demand = C(Ybar-Tbar) + I(r) + Gbar
*I(r) is only endogenous variable (all other fixed/exogenous)
Gov changes taxes
household change C`
Aggregate Supply equation = ?
Ybar = F(Kbar,Lbar)
Aggregate Equilibrium
Formula?
Definition?
Definition: where aggregate supply meets aggregate demand, and r changes to equate them both
Equilibrium: Ybar = F(Kbar,Lbar) = C(Ybar-Tbar) + I(r) + Gbar
what are loanable funds?
Who are the players in the market?
Demand for funds: investment (mainly firms, some households)
Supply for funds: saving (mainly households, also gov if surplus)
Price of funds: real interest rate (determined by S and D)
*In turn determines the EQ in the market G&S
what determines the demand for Loanable funds
investment curve represents the demand curve for loanable funds
(depends negatively on r)
What can cause investment curve/loanable funds demand to rise
business more optimistic economy
expect high profit
less business tax
tech change
what players determine supply of loanable funds
households (deposits) and government (if surplus tax revenue) in the form of savings
3 Types of saving and equations
Private saving = (Y-T)-C
Public Saving = T-G
National saving = private + public saving = Y-C-G
*remember:
y(supply) must =demand in EQ
as G changes, C and I change to keep EQ
change in demand are related to change in C or I (maintain eq since y fixed)
What are the conditions of budget surplus, deficit, and balanced budget
T > G -> budget surplus
T < G -> budget deficit (public saving negative)
T = G -> balanced budget (public saving =0)
Supply Curve for loanable funds (equation)?
national saving independent r, supply vertical (fixed)
Sbar = Ybar - C(Ybar-Tbar) - Gbar (all fixed)
what is the special role of r (real interest rate)
adjusts to equilibrate goods market and loanable funds market simultaneously
Loanable Funds market in eq: Y-C-G=I
* Transfer to goods market by add (C+G) each side
* Goods market in eq: Y = C+I+G
Thus: EQ in LF market = EQ in goods market
what is fiscal policy and what does it impact?
Fiscal policy is government changes in spending and level of tax
Impacts: 1. D for output G&S 2. Alter national saving/investment/and EQ interest rate
increases in government purchases are met by…
equal decreases in investment (since T and C remain unchanged)
Y = C + I + G (I falls and G rises)
how does government finance additional spending? what changes and remains constant?
finance spending by borrowing (reducing public saving)
private saving unchanged, gov borrowing reduces national saving
S = Y – C – G (S falls and G rises)
Reduce saving -> supply LF shift left -> increase EQ r -> crowd out (I)
how does reduction in taxes (fiscal policy) effect saving and investment?
Tax cut -> raise (Y-T) by changeT -> C rises by MPC*changeT
*New Disposable income (after tax cut) = (Y-T) + changeT
New Consumption (after tax cut) = C + MPCchangeT
National Saving (S = Y-C-G) falls by MPC*changeT
New National Savings: S = Y-C-G – MPCchangeT
where MPC*changeT: portion of change in taxes that consumers will spend (rather than save)
why might investment demand increase (2 reasons)
technological innovation, tax laws
When investment demand increases, what impact on EQ of I and EQ r?
o EQ of I remain unchanged (amount invested depends on a fixed level of saving aka. supply of LF)
o EQ rate increases: since supply fixed, investment shift up only changes r (not I)
when saving depends on r (supply not fixed), what impact on EQ I and r?
increase in r -> household consume less -> save more -> more resources for investment (supply rises)
Graphically: increase in demand for investment -> causes raise interest rates -> cause raise in EQ investment and saving
How do you find the Equilibrium values for Y, C, I, r, and S(national saving)?
Equilibrium is when total output for G&S market = total
When is the loanable funds market in EQ?
when Y-C-G=I
When is G&S market in equilibrium?
when Y = C+I+G
How are the G&S and LF markets related?
r changes to adjust to ensure EQ is reached in both markets simultaneously.
Thus;
Loanable Funds market in eq: Y-C-G=I
* Transfer to goods market by add (C+G) each side
* Goods market in eq: Y = C+I+G
Thus: EQ in LF market = EQ in goods market
what is closed economy output used for (3 things)
consumption, government spending, investment
total output (Y) determined by what factors?
economy quantity of K, L and technology
Competitive firms hire each factor until ___ (condition)
MP = MC or MP=P
if the production function has CRS, how caan we express total income (formula)?
Labor income + capital income = total income
what causes r to rise and I to fall?
decrease in national saving (S) caused by government spending (fiscal policy)
what causes r to rise but does not impact EQ level of I (since supply fixed)?
increase in investment demand
