Summary

1. The factors of production and the production technology determine the economy’s output of goods and services. An increase in one of the factors of production or a technological advance raises output.

2. Competitive, profit-maximizing firms hire labor until the marginal product of labor equals the real wage. Similarly, these firms rent capital until the marginal product of capital equals the real rental price. Therefore, each factor of production is paid its marginal product. If the production function has constant returns to scale, then according to Euler’s theorem, all output is used to compensate the inputs.

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3. The economy’s output is used for consumption, investment, and government purchases. Consumption depends positively on disposable income. Investment depends negatively on the real interest rate. Government purchases and taxes are the exogenous variables of fiscal policy.

4. The real interest rate adjusts to equilibrate the supply and demand for the economy’s output—or, equivalently, the supply of loanable funds (saving) and the demand for loanable funds (investment). A decrease in national saving, perhaps because of an increase in government purchases or a decrease in taxes, decreases the supply of loanable funds, reduces the equilibrium amount of investment, and raises the interest rate. An increase in investment demand, perhaps because of a technological innovation or a tax incentive for investment, increases the demand for loanable funds and also raises the interest rate. An increase in investment demand increases the quantity of investment only if a higher interest rate stimulates additional saving.