Chapter 3: National Income – Where it Comes From & Where It Goes
Most important macroeconomic variable: GDP; does
not ensure happiness, but it’s the best recipe for it
Households use income to pay taxes, to consume
goods/services, & to save through financial markets.
Firms receive revenue from sale of goods and
services, and use it to pay for the FoP
Both households and firms borrow in financial
markets to invest(housing, factories)
Government uses tax revenue for gov’t purchases
Public saving: excess tax revenue can be positive or
negative (budget surplus/deficit)
3.1 – 2 Things Determine the Total Production of Goods/Services: FoP & PF
Factors of Production
Inputs used to produce goods and services; if this rises, so does output
2 most important FoP assume these are fixed (they have the overbar) & fully utilized
- Capital(K): tools that workers use Physical capital = machines & Knowledge= human capital
- Labour(L): time people spend working
Production Function (PF)
Ability to turn inputs (given K and L) into output this ability is determined by technology
Represents the relationship between available technology & the Y that can be produced from K, L
PF = Y = F(K, L) output is a function of the amount of capital and labour
Constant returns to scale: if an increase of an equal % in all FoP causes an increase in output of the
same %. zY = F(zK, zL) for any positive number z (so assume MPL and MPK positive)
Competitive, profit-maximizing firms hire labour until marginal product of labour (MPL) = real wage,
and they rent capital until marginal product of capital (MPK) = real rental price.
fixed PF & FoP determine quantity supplied (& full employment real GDP)
3.3 – What Determines the Demand for Goods & Services?
Closed economy: assume the country does not trade with other countries. The circular flow diagram
contains only C, I, and G (not NX) Y = C + I + G = PE (aggregate planned expenditure)
Consumption – 56% of GDP
Income households receive = output of economy Y. Y = amount that government taxes households
Disposable income (Y – T): income after payment of taxes it’s divided into consumption & saving
C = C(Y-T) because the level of consumption depends directly on level of disposable income
- Consumption function: relationship between consumption & disposable income
Marginal propensity to consume (MPC): slope of consumption function; amount by which C
changes when Y changes by $1. MPC = (change in C) / (change in Y – T)
- 0 T or G < T, there is a surplus or deficit/debt)
Government purchases and taxes are exogenous variables, so they are fixed (overbar!)
- The endogenous variables are C, I, and r (so they’re impacted by fiscal policy, which is defined as
changes in the level of government purchases and taxes)
3.4 – What Brings the S & D for Goods & Services into Equilibrium (E)?
In the classical model, the interest rate is the P that is crucial in equilibrating S and D
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