National Income: Where It Comes From and Where It Goes The basic Classical Model of the economy discussing how much the economy produces, who gets the income from production, and how the economy’s resources are allocated among alternative 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 Function b Production refers to the transformation of inputs into output; b A production function is a flow concept; b A production function is a physical, technological, or engineering concept, and yet it has an economic dimension to it; and b In production analysis, factors of production 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 Variable Input (Labor)

Who Uses the Economy’s Output in a Closed Economy? b Households purchase some the economy’s output for consumption, C; b Business firms and households use some of the economy’s output for investment, I; and b Governments buy some of the economy’s output for public purposes, G.

Who Uses the Economy’s Output in an Open Economy? b Households purchase some the economy’s output for consumption, C; b Business firms and households use some of the economy’s output for investment, I; b Governments buy some of the economy’s output for public purposes, G; and b Foreigners purchase some of the economy’s output for consumption, X.

Planned Aggregate Expenditures in an Open Economy b Consumption Expenditures C = C d + C fC = C d + C f b Investment Expenditures I = I d + I fI = I d + I f b Government Expenditures G = G d + G fG = G d + G f b Foreign Sector’s Expenditures X

Consumption Function According to Keynes In the Short Run: C = f ( Y D ) where Y D = Y - T Thus,C = f ( Y - T ) The Keynesian Consumption Function: C = a + mpc( Y- T ) C = a + mpc(1 - t) Y

Investment Expenditures Investment (I) is inversely related to the real interest rate I = f ( r ) where r is the real interest rate.

Government Expenditures There are two types of government spending: b Government Purchases of Goods and Services (G); and b Government Transfer Payments to House- holds (TR). Government purchases of goods and services account for about 20 percent of GDP in the United States.

Saving in a Closed Economy b National Saving (S): the output that remains after the demands of households and the government have been satisfied Y - C - G National Saving is the sum of: b Private Saving: disposable income minus consumption: Y - T - C b Public Saving: T - G

Saving in an Open Economy b National Saving (S): the output that remains after the demands of households and the government have been satisfied Y - C - G = I + NX or S = I + NX S - I = NX Net Foreign Investment = Trade Balance