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Chapter 3 - National Income Where It Comes From & Where It Goes.docx

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Karen Huff

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  2
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