MACROECONOMICS
Chapter 3
National Income: Where
It Comes From and
Where It Goes
Sources and Uses of GDP
How much GDP is produced by the firms
in an economy?
 How the income is divided between labor
and capital owners?
 Who buys the output of the economy?
 How does the demand for goods and
services match the supply of goods and
services?

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How Much GDP?
Think of the whole economy as a
production function: Y=F(K,L)
 In the LONG RUN, markets clear.

No unemployment in the factor markets.
 The amount of K and L are thus determined.


The total amount of Y (GDP=Income) is
thus determined.
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Who Gets What?

In perfectly competitive factor markets, the
demand for an input is its marginal
product.
MPL = ΔY/ΔL
 MPK = ΔY/ΔK


The supply of a factor was determined to
be K-bar and L-bar.
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Factor Shares
R
(MPK)P
K
W
Q of K
(MPL)P
L
Q of L
The demand for capital is the value of the marginal product of capital: P(MPK)
The demand for labor is the value of the marginal product of labor: P(MPL)
Explain equilibrium.
At equilibrium R = P(MPK) and W = P(MPL)
WL is labor’s share in $; RK is capital’s share in $
5
Shares of Factors

If all the firms are operating in perfectly
competitive markets, then P=AC=MC and
economic profits (PQ-WL-RK) is zero.
PQ = WL + RK
 Q = (W/P)L + (R/P)K
 Y = (MPL)L + (MPK)K


Senator Paul Douglas noticed that (1920s)
the share of labor in the national income
remained constant through the years.
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Shares of Factors

What kind of a production function would
pay each factor their marginal products
and the marginal products would remain a
constant share of the total income?
MPL = α(Y/L)
 MPK = (1-α)(Y/K)


Cobb-Douglas production function.
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Cobb-Douglas Production Function

It turns out that a function in the following form
fulfils the required condition.

Y  AL K
K
L  LK
Y
Y
Y
L
L
L
 AK
1
L
1 

AK
L

 Y
L
 1
L
Y
Y
Y
1
K
K
K
 (1   ) AL K 1 1

1
(
1


)
AL
K

 (1   )Y
K
K
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Properties of Cobb-Douglas


Constant returns to scale: zY=F(zL,zK)
Declining marginal products: negative 2nd
derivative
Y
K
Y
Y=F(L,K)
MPL
2b
2Y
b
Y
a
2a
L
L
L
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Who Buys the GDP?
Y  C  I  G  NX
C  C (Y  T )
I  I (r )
For simplicity, let’s assume that NX=0
If labor and capital are fixed, Y is fixed.
So, the only variable that determines
how demand will match supply is r.
_
G G
_
T T
S  S GOV  S HH
S  T G Y C T
S Y C G
Y  C  T  S HH
S GOV  T  G
I  S HH  S GOV
But from Y = C + I + G
I=Y–C–G
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Circular Flow
Identify the arrows.
Domestic production (GDP) = Expenditures
Income = Expenditures
Savings = Investment
All equalities imply market clearing.
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Another View of Equilibrium
Expenditures
C+I+G
C=c(Y-T)
Y-bar
Y
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Equilibrium in the Financial Markets
r
GOV
S HH
S S
What happens if
government budget
has a deficit?
What happens if
investment demand rises?
What happens to
investment demand
during recessions?
I
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