National Income: Where It National Income: Where It Comes From and Where It GoesComes From and Where It Goes

The basic The basic Classical ModelClassical Model of the of the economy discussing how much the economy discussing how much the economy produces, who gets the income economy produces, who gets the income from production, and how the economy’s from production, and how the economy’s resources are allocated among alternative resources are allocated among alternative uses.uses.

Production Function: Y = f ( K,L )

The functional relationship given by technology between a firm’s rates of input and its physical rates of output per unit of time

Characteristics of a Production Characteristics of a Production FunctionFunction

Production refers to the transformation of Production refers to the transformation of inputs into output;inputs into output;

A production function is a flow concept;A production function is a flow concept; A production function is a physical, A production function is a physical,

technological, or engineering concept, and yet technological, or engineering concept, and yet it has an economic dimension to it; andit has an economic dimension to it; and

In production analysis, factors of production In production analysis, factors of production can be separated into fixed and variable.can be separated into fixed and variable.

Demand for a Factor of Production

Derived Demand: The demand for a factor is a result of the demand for the products the factor helps to produce.

Production Function with One Production Function with One Variable Input (Labor)Variable Input (Labor)

Labor Output MPL MRP

1 6 6 60

2 14 8 80

3 24 10 100

4 32 8 80

5 38 6 60

6 42 4 40

7 44 2 20

8 44 0 0

Who Uses the Economy’s Output Who Uses the Economy’s Output in a Closed Economy?in a Closed Economy?

Households purchase some the economy’s Households purchase some the economy’s output for consumption, C;output for consumption, C;

Business firms and households use some of Business firms and households use some of the economy’s output for investment, I; andthe economy’s output for investment, I; and

Governments buy some of the economy’s Governments buy some of the economy’s output for public purposes, G.output for public purposes, G.

Who Uses the Economy’s Output Who Uses the Economy’s Output in an Open Economy?in an Open Economy?

Households purchase some the economy’s Households purchase some the economy’s output for consumption, C;output for consumption, C;

Business firms and households use some of Business firms and households use some of the economy’s output for investment, I;the economy’s output for investment, I;

Governments buy some of the economy’s Governments buy some of the economy’s output for public purposes, G; andoutput for public purposes, G; and

Foreigners purchase some of the economy’s Foreigners purchase some of the economy’s output for consumption, X.output for consumption, X.

Planned Aggregate Expenditures Planned Aggregate Expenditures in an Open Economyin an Open Economy

Consumption ExpendituresConsumption Expenditures• C = CC = Cdd + C + Cff

Investment ExpendituresInvestment Expenditures• I = II = Idd + I + Iff

Government ExpendituresGovernment Expenditures• G = GG = Gdd + G + Gff

Foreign Sector’s ExpendituresForeign Sector’s Expenditures• XX

Consumption Function Consumption Function According to KeynesAccording to Keynes

In the Short Run:In the Short Run:

C = C = ff ( Y ( YDD))

where Ywhere YDD = Y - T = Y - T

Thus,Thus, C = C = ff ( Y - T ) ( Y - T )

The Keynesian Consumption Function:The Keynesian Consumption Function:

C = a + mpc( Y- T )C = a + mpc( Y- T )

C = a + mpc(1 - t) YC = a + mpc(1 - t) Y

Investment ExpendituresInvestment Expenditures

Investment (I) is inversely related to the real Investment (I) is inversely related to the real interest rate interest rate

I = I = ff ( r ) ( r )

where r is the where r is the real interest ratereal interest rate..

Government ExpendituresGovernment Expenditures

There are two types of government spending:There are two types of government spending: Government Purchases of Goods and Government Purchases of Goods and

Services (G); andServices (G); and Government Transfer Payments to House-Government Transfer Payments to House-

holds (TR).holds (TR).

Government purchases of goods and services Government purchases of goods and services account for about 20 percent of GDP in the account for about 20 percent of GDP in the

United States.United States.

Saving in a Closed EconomySaving in a Closed Economy

National Saving (S): the output that remains National Saving (S): the output that remains after the demands of households and the after the demands of households and the government have been satisfiedgovernment have been satisfied

Y - C - GY - C - G

National Saving is the sum of:National Saving is the sum of: Private Saving: disposable income minus Private Saving: disposable income minus

consumption: Y - T - Cconsumption: Y - T - C Public Saving: T - GPublic Saving: T - G

Saving in an Open EconomySaving in an Open Economy

National Saving (S): the output that remains National Saving (S): the output that remains after the demands of households and the after the demands of households and the government have been satisfiedgovernment have been satisfied

Y - C - G = I + NXY - C - G = I + NX

oror

S = I + NXS = I + NX

S - I = NXS - I = NX

Net Foreign Investment = Trade BalanceNet Foreign Investment = Trade Balance