national income savings and investment
TRANSCRIPT
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National Income
Savingsand Investment
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Circular Flow of Income
• In a VERY simple economy– Labor is a factor input used to produce goods– Labor receives income of wages
• Wages then exchanged for goods
Producers
Wages/Goods
Factor Inputs/
Consumers
Labor/Payments
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Supply
Demand
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Measures of Economic Activity
1. Labor services sold for wages ("supply side“)2. Goods sold for revenue ("demand side“)
Note that Total Income (received by the workers) must equal Total Spending
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Generality
• Basic logic of circular flow does not change with addition of:– Financial Markets (the future), assets, money, bonds, …
– Government taxing/spending, …– International Exchange (trade) of goods, services, capital …
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Gross Domestic Product• GDP ("output") is defined as the value of all final goods
and services produced within the country at current prices– GDP a flow measure (usually annual)– Output is valued at market prices (something priced at zero is not included)
– Only final goods and services count, so that value‐added is measured
– Inflation makes nominal GDP uninteresting over long periods of time
• Real GDP is real value of all goods and services, accounting for inflation
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Many Issues with National Accounts
• Leisure is ignored but valuable• Income distribution relevant• Non‐Market Services (those not priced) are ignored but important
• Environmental Degradation• Underground Economy generates value • Statistical Problems
– mis‐measurement is rife (e.g., CPI “quality bias”)– 2 important examples: a) rising quality; b) new goods
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Modeling Income: “Supply” Side
• Standard microeconomics• Output produced from input factors labor and capital, given at point in time
• Factors combined with production functionwhich maps inputs to output via (short‐run) fixed technology– Y = F(K, L)– GDP (Y) produced from capital (K) and labor (L) using existing technology F(.)
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An Important Assumption
• Constant Returns to Scale (CRS)– Doubling inputs doubles output– Replication
• Usually assume competitive input markets and profit maximization–With CRS, economic profits are zero
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An Important Fact
• The “Cobb‐Douglas” Production Function works (surprisingly) well empirically:
Y=AKL1‐– where ≈ .25/.33 empirically– is capital’s share of income (rK/Y)– (1‐) is labor’s share of income (wL/Y)– A represents technology
• Empirical (rather than theoretical) finding– Can be treated as constant?
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Demand (Expenditure) Side
The “National Income Accounting Identity”
Y C + I + G + (X‐M)
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Consumption (C)
• Consumption is undertaken by households– Approximately 60% of aggregate spending on average
1. Mostly Services (in Rich Countries)2. Goods
– Durables – Non‐Durables– Important in Developing Countries
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Investment (I)
• Physical Investment in Capital is undertaken by firms– Slightly more than 20% of aggregate spending on average
1. Depreciation2. Structures
– Residential – Non‐residential
3. Machinery and Equipment4. Research and Development (new)5. Change in Inventories
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Direct Government Spending (G)
• Government directly purchases goods and services (for “public consumption”)
– Slightly less than 20% aggregate spending on average– Different levels of government– Major components:
1. Healthcare2. Education3. Military4. Infrastructure, …
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Indirect Government Spending
Who Receives Transfers?1. Old2. Unemployed3. Poor4. Agriculture5. Bond‐holders (Holders of National Debt), …
• Note: indirect spending often larger than direct government spending
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Net Exports (NX)
• Net Exports = exports (X) minus imports (M)
• That is, our sales to foreigners, less our
purchases from foreigners
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Modeling Aggregate Spending
• Assume:– Consumption a function of (disposable) income with slope, c Marginal Propensity to Consume (MPC) so that C=cY• Note: no effect of interest rates on consumption, and hence no interest effect on savings– Theoretically ambiguous, empirically weak
– Investment a function of the (real) interest rate, Present Value
– Direct Government Purchases and Net Exports are both exogenous, latter zero
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Equilibrium: Formal Stuff
• Combine Demand and Supply Models– Supply side: Y = F(K,L) – Demand side: Y = C + I + G + (X‐M)
• But C = c(Y); I = I(r); G fixed; (X‐M) = 0
• Factor supplies and output fixed in the short run: Y = c(Y) + I(r) + G– Alternatively, Y = C + I + G
=> Y ‐ C ‐ G = I => (Y ‐ C ‐ G) = I=> National Savings = Investment
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Equilibrium
• S = Y ‐ C – G = I(r)
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r
S, I
I(r)
S = Y – C(Y) - G
A = equilibrium
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What Happens when G Rises?
• Increase in Direct Government Spending (e.g., war financed by deficit)– Savings (S) and hence Investment (I) contract – Interest rate (r) rises, endogenously
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r
S, I
A
B
I(r)
S = Y – C(Y) - G′
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Technological Innovation
• Increase in Investment Schedule (shifts up)– Interest rate (r) increases endogenously– No change in Savings or Investment
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r
S, I
A
B
I(r)
S = Y – C(Y) - G
I’(r)
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Key Takeaways
• Circular Flow of Income• Production Function
– Y=F(K,L)
• National Income Accounting Identity– Y=C+I+G+(X‐M)
• In a closed economy, investment and savings interact to determine the interest rate
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