Chapter 3: National income

Question 1

What determines the supply side of the total production of goods and services?

Answer 1

Supply is determined by quantity of inputs (factors of production) and ability to turn inputs into output (the production function)

Question 2

What does the production function look like and what does it reflect?

Answer 2

Y = F(K,L)

Reflects the level of technology of the economy

Question 3

What are the assumptions of the production function?

Answer 3

Technology is fixed

Constant returns to scale

The economy’s supplies of capital and labour are fixed at: K=K ̅ and L=L ̅

Question 4

What is the distribution of national income determined by?

Answer 4

Factor prices - The prices per unit that firms pay for the factors of production. I.e. the wage workers earn, and the rent owners of capital collect.

Question 5

What is W/P and R/P?

Answer 5

The real wage rate and real rental rate respectively

Both measured in units of output

Question 6

What is the optimal amount of labour for a firm to hire?

Answer 6

In optimum, MPL = W/P

The real wage adjusts to equate labour demand with supply

Question 7

What is the MPK curve?

Answer 7

The firm’s demand curve for renting capital. Firms maximize profits by choosing K such that MPK = R/P

Question 8

How is total output divided between the payments to capital and labour?

Answer 8

Total output is divided between the payments to capital and the payments to labour, depending on their marginal productivities

The real wage paid to each worker = MPL
Real rental price of capital = MPK

Y= (MPLL) + (MPKK) + Economic profit

If there is constant returns to scale, economic profit is zero

Question 9

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

Answer 9

The Cobb-Douglas production function

F(K,L)=A K^α L^(1-α)

Question 10

What is the parameter A in the Cobb-Douglas function and what does it imply?

Answer 10

A is a parameter greater than zero that measures the productivity of the available technology

A technological advance that increases the parameter A raises the marginal product of both factors proportionally.

Question 11

According to the Cobb-Douglas production function, what does an increase in the amount of capital mean?

Answer 11

An increase in the amount of capital raises the MPL and reduces MPK and vice versa.

Question 12

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

Answer 12

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

Question 13

What is α and 1 - α in the Cobb-Douglas production function?

And what do they imply?

Answer 13

(1-α)Y the total amount paid to labour - hence, (1-α) is labour’s share of output

αY - the total amount paid to capital, α is capital’s share of output

The ratio of labour income to capital income is constant

Question 14

What do housholds use their disposable income for?

Answer 14

Households divide their disposable income between consumption and savings.

Question 15

What is the consumption function?

Answer 15

C=C(Y-T)

Relationship between consumption and disposable income

Question 16

What is the marginal propensity to consume?

Answer 16

The marginal propensity to consume (MPC) = the amount by which consumption changes when disposable income increases by one euro

I.e. the increase in C caused by a one-unit increase in disposable income. MPC is between 0 and 1

Question 17

What is the slope of the consumption function?

Answer 17

MPC

Question 18

What does the quantity of investment goods demanded depend on?

Answer 18

The interest rate

Question 19

What is the investment function?

Answer 19

I=I(r)

Relates quantity of investment I to real interest rate

Question 20

What does it mean that we take government purchases and taxes as exogenous variables?

Answer 20

G=G ̅
T=T ̅

Government purchases and taxes are the exogenous variables set by fiscal policy makers.

Question 21

What brings the supply and demand into equilibrium?

Answer 21

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

The interest rate must adjust to ensure that the demand for goods equals the supply.

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

The greater the interest rate, the lower level of investment and thus the lower demand for goods and services

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

Question 22

What is Y - C - G (and (Y - T) - C and T - G)?

Answer 22

Y - C - G is the output that remains after the demands of consumers and the government have been satisfied - national saving or saving (S)

((Y - T) - C) - disposable income minus consumption, i.e. private saving

(T - G) public saving

S = (Y - T - C) + (T - G) = I

Question 23

What does the following equation imply?

Answer 23

Y ̅ - C(Y ̅ - T ̅ )- G ̅= I(r)
S ̅=I(r)

G and T are fixed by policy and Y is fixed by the factors of production and the production function

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

Question 24

Why does investment decrease if there is an increase in government purchases (and thus demand for goods and services)?

Answer 24

As total output is fixed by factors of production and consumption is unchanged (because disposable income Y - T is unchanged) there must be a decrease in investment

Because the increase in government purchases is not accompanied by an increase in taxes, the government finances the additional spending by borrowing - i.e. reducing public saving.

A reduction in national savings - leftward shift of supply of loanable funds. Hence, at the initial interest rate, the demand for loanable funds exceeds the supply –> increase in interest rate

Question 25

Why must a decrease in taxes also be met by a decrease in investment?

Answer 25

Consumption rises by an amount equal to the change in taxes times the marginal propensity to consume MPC. The higher the MPC, the greater the impact of the tax cut on consumption. Savings fall by the amount consumption rises

Hence, supply falls and interest rates must rise

Question 26

The equilibrium amount of investment will not change if there is a change in demand for investments. Why?

Answer 26

An increase in investment demand just increases equilibrium interest rate

Under our assumptions, the fixed level of saving determines the amount of investment - fixed supply of loanable funds.

However, if we modify assumptions to allow consumption to depend on interest rate, the saving schedule would be upward sloping

Hence, a change in investment demand would both raise equilibrium price and quantity