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21(9)
Economic Growth, the
Financial System, and
Business Cycles
Chapter
Brief Chapter Summary
21.1 Long-Run Economic Growth (pages 696-703)
Learning Objective 1 Discuss the importance of long-run economic growth.
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The U.S. economy has experienced both long-run economic growth and short-run periods of
expansion and recession.
Long-run economic growth results in rising productivity and increases in the average standard of
living.
Because of economic growth, the average American today can buy more than eight times as much
as the average American in 1900. Long-run growth is measured by increases in real GDP per
capita. Increases in real GDP per capita depend on increases in labor productivity.
Labor productivity is the quantity of goods and services that can be produced by one worker or by
one hour of work.
Economists believe two key factors determine labor productivity: The quantity of capital per hour
worked and the level of technology. Therefore, economic growth occurs if the quantity of capital
per hour worked increases and if technological change occurs.
21.2 Saving, Investment, and the Financial System (pages 703-712)
Learning Objective 2 Discuss the role of the financial system in facilitating long-run economic
growth.
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Financial markets and financial intermediaries together comprise the financial system. A wellfunctioning financial system is an important determinant of economic growth.
Firms acquire funds from households, either directly through financial markets—such as the
stock and bond markets—or indirectly through financial intermediaries—such as banks. The
funds available to firms come from saving.
There are two categories of saving in the economy: private saving by households and public saving
by the government. The value of total saving in the economy is always equal to the value of total
investment spending. In the market for loanable funds, the interaction of borrowers and lenders
determines the market interest rate and the quantity of loanable funds exchanged.
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CHAPTER 21 (9) | Economic Growth, the Financial System, and Business Cycles
21.3 The Business Cycle (pages 712-721)
Learning Objective 3 Explain what happens during a business cycle.
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A business cycle consists of alternating periods of economic expansion and contraction. During
the expansion phase of a business cycle, production, employment, and income are increasing.
The period of expansion ends with a business cycle peak. Following the business cycle peak,
production, employment, and income decline during the recession phase of the cycle.
The recession comes to an end with a business cycle trough, after which another period of
expansion begins. The inflation rate usually rises near the end of a business cycle expansion and
then falls during a recession.
The unemployment rate declines during the latter part of an expansion and increases during a
recession. The unemployment rate often continues to increase even after an expansion has begun.
Recessions are difficult to predict because they have more than one cause. Recessions have been
milder and the economy has been more stable since 1950.
Chapter Outline
Growth and the Business Cycle at Boeing
Over the past several years, Boeing has experienced an increase in orders as a result of economic growth
in the United States, Europe, and several Asian countries. In 2007, the firm experienced a record 1,413
orders for new commercial jets. While benefiting from economic growth, Boeing has been vulnerable to
the business cycle. For example, the U.S. economy experienced a recession in 2001, which together with
the terrorist attacks on September 11, caused orders for Boeing’s commercial aircraft to decline by 45
percent.
>>
Teaching Tips
At the beginning of this chapter, Economics in YOUR Life! asks
students if spending instead of saving will promote economic growth.
Students can compare their answers with those provided by the authors at
the end of the chapter. An Inside Look at the end of this chapter
discusses how China’s domestic aviation market, which is the second
largest in the world, is struggling because of a shortage of trained
workers. You can use these readings as the basis for classroom
discussion, homework assignments, or examination questions.
21.1 LEARNING OBJECTIVE
21-1 Long-Run Economic Growth (pages 696-703)
Learning Objective 1 Discuss the importance of long-run economic growth.
A key measure of success of any economy is its ability to increase production of goods and services faster
than the growth in population. The U.S. economy has experienced periods of expanding production and
employment followed by periods of recession, during which production and employment decline. The
business cycle refers to alternating periods of economic expansion and economic recession. The business
CHAPTER 21 (9) | Economic Growth, the Financial System, and Business Cycles
479
cycle is not uniform: Each period of expansion is not the same length, nor is each period of recession.
Most people in the United States, Western Europe, Japan, and other advanced countries expect that, over
time, their standard of living will improve. Long-run economic growth is the process by which rising
productivity increases the average standard of living. The best measure of the standard of living is real
GDP per capita. Long-run economic growth is measured by increases in real GDP per capita.
A. Calculating Growth Rates and the Rule of 70
The growth rate of real GDP or real GDP per capita during a particular year is equal to the percentage
change from the previous year. One way to calculate approximately how many years it will take real
GDP per capita to double is to use the rule of 70. The formula for the rule is:
Number of years to double =
70
Growth rate
B. What Determines the Rate of Long-Run Growth?
Increases in real GDP per capita depend on increases in labor productivity. Labor productivity is the
quantity of goods and services that can be produced by one worker or by one hour of work. Economists
usually measure labor productivity as output per hour of work in order to avoid fluctuations in the length
of the workday and in the fraction of the population employed. Economists believe that two key factors
determine labor productivity: The quantity of capital per hour worked and the level of technology.
Capital refers to manufactured goods that are used to produce other goods and services. The total amount
of physical capital (such as computers, factory buildings, and trucks) available in a country is known as
the country’s capital stock. As the capital stock per hour worked increases, worker productivity increases.
Human capital refers to the accumulated knowledge and skills workers acquire from education and
training or from their life experiences. Increases in human capital stimulate economic growth. Economic
growth depends more on technological change than on increases in capital per hour worked. Technology
refers to the process a firm uses to turn inputs into outputs of goods and services. Technological change is
an increase in the quantity of output firms can produce using a given quantity of inputs. Most
technological change is embodied in new machinery, equipment, or software.
C. Potential Real GDP
Potential GDP is the level of GDP attained when all firms are producing at capacity. Growth in potential
real GDP in the United States is estimated to be about 3.5 percent per year.
>>
Teaching Tips
Use classroom discussion, numerical examples, and homework
assignments to help your students understand how growth rates are
computed. Assign Solved Problem 21-1 and end-of-chapter problems
1.8 and 1.12 to reinforce students’ understanding of these topics. Use
Making the Connection: The Connection between Economic
Prosperity and Health to explain how technological change affects
economic prosperity and health. Making the Connection: What
Explains Rapid Economic Growth in Botswana? show how Botswana’s
rapid economic growth is related to government policies that protect
private property.
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CHAPTER 21 (9) | Economic Growth, the Financial System, and Business Cycles
21.2 LEARNING OBJECTIVE
21.2 Saving, Investment, and the Financial System (pages 703-712)
Learning Objective 2 Discuss the role of the financial system in facilitating long-run economic
growth.
A. An Overview of the Financial System
Firms can finance their expansion from retained earnings, through financial markets, and through
financial intermediaries. The financial system is the system of financial markets and financial
intermediaries through which firms acquire funds from households. Financial markets are markets
where financial securities, such as stocks and bonds, are bought and sold. Financial intermediaries are
firms, such as banks, mutual funds, pension funds, and insurance companies that borrow funds from
savers and lend them to borrowers. There is no country without a well-developed financial system that
has been able to sustain high levels of economic growth. The financial system provides three key services
for savers and borrowers:
a. Risk sharing. Risk is the chance that the value of a financial security will change relative to what you
expect)
b. Liquidity (i.e., the ease with which a financial security can be exchanged for money), and
c. Information (i.e., the facts about borrowers and expectations about returns on financial securities).
B. The Macroeconomics of Saving and Investment
The total value of saving in the economy must equal the total value of investment. There are two
categories of saving in the economy: private saving by households and public saving by the government.
When the government spends the same amount that it collects in taxes, there is a balanced budget. When
the government spends more than it collects in taxes, there is a budget deficit. Negative saving is also
known as dissaving. When the government spends less than it collects in taxes, there is a budget surplus.
A budget surplus increases public saving and the total level of saving in the economy. Therefore, there is
a higher level of investment spending in the economy when there is a budget surplus than when there is a
balanced budget.
C. The Market for Loanable Funds
The market for loanable funds refers to interaction of borrowers and lenders that determines the market
interest rate and the quantity of loanable funds exchanged. An increase in the demand for loanable funds
increases the equilibrium interest rate. As a result, the equilibrium quantity of loanable funds increases.
When the government begins running a budget deficit, the supply of loanable funds shifts to the left. The
equilibrium interest rate increases. As a result, the equilibrium quantity of loanable funds decreases.
Crowding out refers to a decline in private expenditures as a result of an increase in government
purchases.
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Teaching Tips
Students usually confuse the role of investment and saving in economic
growth. Use Making the Connection: Ebenezer Scrooge: Accidental
CHAPTER 21 (9) | Economic Growth, the Financial System, and Business Cycles
481
Promoter of Economic Growth? to clarify the different roles of
consumption and saving. Assign Solved Problem 21-2 and related end-ofchapter problem 2.16 to reinforce students’ understanding of these topics.
Encourage students to study the following three figures:
Figure 21-3, which illustrates the market for loanable funds.
Figure 21-4, which shows the effects of an increase in the demand for
loanable funds.
Figure 21-5, which depicts the effects of a budget deficit on the market
for loanable funds.
21.3 LEARNING OBJECTIVE
21.3 The Business Cycle (pages 712-721)
Learning Objective 3 Explain what happens during a business cycle.
A. Some Basic Business Cycle Definitions
During the expansion phase of a business cycle, production, employment, and income are increasing. The
period of expansion ends with a business cycle peak. Following the business cycle peak, production,
employment, and income decline during the recession phase of the cycle. The recession comes to an end
with a business cycle trough, after which another period of expansion begins.
B. What Happens during a Business Cycle?
Each business cycle is different. A recession will often begin with a decline in spending by firms on capital
goods or by households on new houses and consumer durables. The inflation rate usually rises near the end
of a business cycle expansion and then falls during a recession. The unemployment rate declines during the
latter part of an expansion and increases during a recession. The unemployment rate often continues to
increase even after an expansion has begun. Economists have not found a method to predict when recessions
will begin and end. Recessions are difficult to predict because they have more than one cause.
C. Why Is the Economy More Stable?
Recessions have been milder and the economy has been more stable since 1950. Economists have offered
three explanations for this:
a. The increasing importance of services and the declining importance of goods,
b. The establishment of unemployment insurance and other government transfer programs that provide
funds to the unemployed, and
c. Active federal government policies to stabilize the economy.
>>
Teaching Tips
Use Figure 21-6 to explain how movements in real GDP generate phases
of the business cycle during the period from 1999 to 2002. Making the
Connection: The Business Cycle and the 2008 explains why an official
determination that the U.S. was in a recession during the 2008 election had
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CHAPTER 21 (9) | Economic Growth, the Financial System, and Business Cycles
not been made, despite the widespread belief that a recession had already
begun. Figures 21-7 through 21-11 illustrate how real GDP, inflation, and
the unemployment rate changed between 1998 and 2008. Don’t Let This
Happen To YOU! clarifies the difference between the price level and the
inflation rate. End-of-chapter problem 3.6 will reinforce students’
understanding of this topic.
Extra Solved Problem 21-3
Leading Indicators and the Business Cycle
Supports Learning Objective 21-3: Explain what happens during a business cycle.
People often ask economists for predictions about the future of the macroeconomy. Forecasts about the
economy’s future, even from experts, are not unlike a baseball writer’s prediction of who will play in the
next World Series. The prediction can seem logical, but it is hardly foolproof. But certain statistical series
tend to move in similar ways through all business cycles. Knowledge of these series and their tendencies
can provide some insight into future business cycle movements. The Conference Board publishes
monthly updates of what is called the “index of leading economic indicators.” The index is a weighted
average of ten statistical series that usually lead, or begin turning upward and downward, before the
overall economy does. Because not all the components in the index turn before the business hits a turning
point (the beginning of a recession or the beginning of an expansion), the movements in the index are
more reliable than the movement in any one of its components.
Among the most reliable of the leading indicators is an index of prices for 500 common stocks. Investors
will want to buy stock shares when their prices are relatively low and sell shares when prices are
relatively high. During a recession, stock prices fall due to sluggish sales and profits. Interest rates are
relatively low during the last months of recessions because of reduced demand for investment. In
choosing between buying bonds and stocks, investors will favor stocks when: (a) stock prices have fallen
to a point where there is a strong possibility of future capital gains, and (b) the opportunity cost of buying
stocks—the interest rate on bonds—is low. Prices of common stocks will usually begin to rise during the
late stages of a business cycle, before a business expansion begins. As the economy moves near full
employment during an expansion, the situation is reversed. Strong demand for consumer goods and
investment will drive prices and interest rates upward. At some point, investors sell stocks to realize
capital gains and buy bonds, rather than stocks, to take advantage of high interest rates. The downward
movement in stock prices will usually begin before a recession begins.
a. Scientists make accurate predictions of the movement of asteroids and comets. Why can’t economists
make similarly accurate predictions of business cycle movements?
b. Assume that the U.S. economy is in a recession. Mild weather results in lower demand for energy and
a reduction in the price of oil. Investors interpret this as positive news for firms because their costs of
production will be lowered. An increase in stock prices results. Will an economic expansion follow?
CHAPTER 21 (9) | Economic Growth, the Financial System, and Business Cycles
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SOLVING THE PROBLEM:
Step 1:
Review the chapter material.
This problem concerns the business cycle, so you may want to review the section “The
Business Cycle,” which begins on page 712 in the textbook.
Step 2:
Answer question (a) by discussing why economists can’t make accurate
predictions of business cycle movements.
The movement of heavenly bodies, unlike human bodies, can be accurately explained by
mathematical formulas. Economists are social scientists who attempt to describe and predict
the behavior of people. People do not behave as predictably as comets.
Step 3:
Answer question (b) by discussing whether an economic expansion is likely to
follow an increase in stock prices.
Stock prices can rise and fall over days or weeks many times before the next turning point in
the business cycle occurs. A sustained rise in stock prices and upward movement in other
leading indicators will increase the probability of an expansion, but remember that economic
forecasts, like baseball World Series forecasts, are only certain after the fact.
Extra Making
Who Decides if the Economy Is in a Recession?
the
Connection
The federal government produces many statistics that make it possible to monitor the economy, but the
federal government does not officially decide when a recession begins or ends. Instead, most economists
accept the decisions of the Business Cycle Dating Committee of the National Bureau of Economic
Research (NBER), a private research group located in Cambridge, Massachusetts. Although writers for
newspapers and magazines often define a recession as two consecutive quarters of declining real GDP,
the NBER has the following broader definition: “A recession is a significant decline in activity spread
across the economy, lasting more than a few months, visible in industrial production, employment, real
income, and wholesale retail trade.” The Business Cycle Dating Committee decided that the U.S.
economy had reached a business cycle peak in March 2001 and a business cycle trough in November
2001, even though real GDP did not decline for two consecutive quarters during this period.
The NBER is fairly slow in announcing business cycle dates because it takes time to gather and analyze
economic statistics. Typically, the NBER will announce that the economy is in a recession only well after
the recession has begun. For instance, the NBER did not announce that a recession had begun in March
2001 until nearly eight months later, at the end of November. November was the same month that the
NBER subsequently decided that the recession had ended, but it did not make this announcement until
July 2003. Similarly, the NBER did not announce that a recession had begun in July 1990 until April
1991, one month after the recession had actually ended. Nonetheless, policymakers look to the NBER to
chronicle the economy’s expansions and contractions.
The following table lists the business cycle peaks and troughs identified by the NBER for the years since
1950. The length of each recession is the number of months from the peak to the following trough:
PEAK
TROUGH
LENGTH OF RECESSION
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CHAPTER 21 (9) | Economic Growth, the Financial System, and Business Cycles
July 1953
May 1954
10 months
August 1957
April 1958
8 months
April 1960
February 1961
10 months
December 1969
November 1970
11 months
November 1973
March 1975
16 months
January 1980
July 1980
6 months
July 1981
November 1982
16 months
July 1990
March 1991
8 months
March 2001
November 2001
8 months
Sources: NBER Reporter, Fall 2001; and NBER Web site (www.nber.org).
Extra Economics in YOUR Life!
Is a Recession a Perfect Time to Buy a House?
Question: You are considering buying a house. Suppose you read on the newspaper the following
statement made by the National Bureau of Economic Research (NBER) “Real GDP declined for two
consecutive quarters.” How should the statement made by NBER affect your decision to buy a house?
Answer: The price level measures the average prices of goods and services in the economy and the
inflation rate is the percentage increase in the price level from one year to the next. An important fact
about the business cycle is that during economic expansions, the inflation rate usually increases,
particularly near the end of the expansion, and during recessions, the inflation rate usually decreases. On
the other hand, recessions cause the unemployment rate to increase. So, if your job is secure, then it might
be a good time for you to buy a house.
Extra INSIDE LOOK News Article to Use in Class
Here is an extra Inside Look news article and analysis to present in class. They are based on news articles
from the book’s Companion Web Site, www.prenhall.com/hubbard.
Economy’s Leading Indicators Forecast Slower Growth
The Associated Press
Posted 1/23/2006 on MSNBC.com
CHAPTER 21 (9) | Economic Growth, the Financial System, and Business Cycles
485
Summary: Key Points in the Article
December’s Index of Leading Economic Indicators (LEI) points toward continued economic growth,
albeit slower growth, in the near future. The LEI uses a series of economic statistics that typically lead the
economy and, when combined into a single measure, do a reasonably accurate job of forecasting nearterm economic growth.
December’s increase was driven by improvements in six of the ten LEI measures including “consumer
expectations, real money supply, stock prices, average first-time claims for jobless benefits, the interest
rate spread and new orders to manufacturers for consumer goods.”
The coincident and lagging indexes both indicated growth. The consensus of many economists is that
slower, possibly choppy, growth will continue throughout the remainder of 2006. Higher energy prices
and increasing interest rates are considered to be the cause of much of the slowdown.
Thinking Critically Questions
1. Why do consumer expectations impact economic growth forecasts?
2. Why is the stock market a leading indicator of economic growth?
3. Why do new orders for manufacturing consumer goods forecast growth?
SOLUTIONS TO END-OF-CHAPTER EXERCISES
Chapter 21 (9)
Answers to Thinking Critically Questions
1. This change would improve airlines’ profitability over time. First, government-set prices do not reflect the
relative scarcities of resources available to the economy. Therefore, these prices hinder entrepreneurs who
maximize profit by providing goods and services that consumers want, and producing these goods and
services efficiently. Second, if foreign companies could supply China’s domestic air carriers with jet fuel,
the price of jet fuel would likely fall and, hence, the profitability of airlines would rise; and, in any case,
the price of jet fuel would better reflect the relative scarcity of this resource.
2. This policy would most likely not be successful. This is because it would keep afloat domestic air
carriers that are inefficient, but able to survive because of these subsidized loans. In other words, the
industry would gain efficiency and profitability over time if it were forced to respond to market rather
than government-subsidized incentives.
LEARNING OBJECTIVE
LEARNING OBJECTIVE 21.1: Discuss the importance of long-run economic growth.
Review Questions
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CHAPTER 21 (9) | Economic Growth, the Financial System, and Business Cycles
1.1
Real GDP per capita measured in 2000 dollars increased from $4,900 in 1900 to $38,000 in 2007,
representing a nearly 8 fold increase. The increase in real GDP per capita is likely to be smaller than the
true increase in living standards because many of today’s goods and services, such as antibiotics, air
conditioners, and televisions, were not available in 1900.
1.2
The most important factor that explains increases in real GDP per capita in the long run is labor
productivity, which is the quantity of goods and services that can be produced by one worker or by one
hour of work.
1.3 The two key factors that cause labor productivity to increase over time are the quantity of capital
per hour worked and the level of technology.
1.4 Potential real GDP is the level of real GDP attained when all firms are producing at capacity.
Historically, potential real GDP has substantially increased over time.
Problems and Applications
1.5 There is no one correct answer to this question, but are some relevant considerations: An income of
$1,000,000 represents 20 times more basic purchasing power than $50,000 in 2008, so one could have
many more goods and services in 1900 than 2008. Even though there were no automatic dishwashers,
microwaves, or airplanes in 1900, with $1,000,000 one could afford to have servants wash the dishes,
cook, do the laundry, and provide other desired personal services. One could travel in private train cars
and in luxurious suites on ocean liners. With an income of $1,000,000 in you could live what in many
ways would be a more luxurious life than with an income of $50,000 today. However, you would not
have available television, personal computers, the Internet, movies, iPods, DVD players, cell phones or
many other goods that today we often think of as necessities. So, a person living with an income of
$50,000 in 2008 might in fact enjoy a higher living standard than a person living with an income of $1
million in 1900.
1.6
Increases in real GDP per capita not only increase the amount of goods and services available to a
country’s citizens, but also increase life expectancy at birth and allow people to have a higher portion of
leisure time over the course of their lives.
1.7
A positive relationship between economic prosperity and life expectancy may be due to increased
spending on health care in an economy with a higher income level. Therefore, greater economic
prosperity would imply a health care sector that is larger relative to the economy. In addition, because the
use of the health care system increases with age, as life expectancy increases and the average age of the
population increases, we should expect that more people will use the health care system for more years.
This should cause the health care sector in the United States to expand relative to the size of the economy.
1.8
7,101  7,113
x 100 = –0.17%
7,113
7,337  7,101
Growth rate for 1992 =
x 100 = 3.32%
7,101
7,533  7,337
Growth rate for 1993 =
x 100 = 2.67%
7,337
7,836  7,533
Growth rate for 1994 =
x 100 = 4.02%
7,533
Growth rate for 1991 =
CHAPTER 21 (9) | Economic Growth, the Financial System, and Business Cycles
Average annual growth =
487
 0.17%  3.32%  2.67%  4.02%
= 2.46%
4
1.9
Using the rule of 70, it will take approximately 37 (=70/1.9) years for real GDP per capita to
double if it grows at 1.9 percent a year.
1.10
Using the rule of 70, it will take approximately 8 (=70/9) years for real GDP per capita to double
if it grows at 9 percent a year.
1.11
The agricultural sector in the United States compared to China has much more capital equipment
and a higher level of technology.
1.12
In the long run, transforming the economy into a market system will be more important for
China’s economic growth. The movement of workers from agriculture to manufacturing represents a
“one-shot” change that will eventually come to an end. Moving towards market principles will induce
more technological advances and innovations.
1.13
You should agree that productivity is the key factor that raises a country’s living standards, which
represent the average amount of goods and services that its citizens are able to consume. A country can
enjoy a high standard of living only if it can produce a large quantity of goods and services.
1.14
Many countries in sub-Saharan Africa may have faced difficulties in successfully implementing
policies that boost economic growth, such as protecting private property and avoiding political instability
and corruption. In some countries, those in power have been unwilling to share power with rivals. They
may retain power through corruption or military might. They assume – probably correctly – that the
establishment of legal rights enforced by courts would end their power and the wealth that comes with
power used corruptly.
LEARNING OBJECTIVE
LEARNING OBJECTIVE 21.2: Discuss the role of the financial system in facilitating long-run
economic growth.
Review Questions
2.1
A financial system allows businesses to borrow funds to finance purchases of capital equipment,
to train workers, and to adopt new technologies.
2.2
The financial system provides risk sharing by allowing savers to spread their money among many
financial investments. It provides liquidity by providing savers with markets in which they can sell their
holdings of financial securities. The financial system provides information by specializing in gathering
information on borrowers and by communicating information on businesses by incorporating that
information into the prices of stocks and bonds.
2.3
The equality between saving and investment follows from national income accounting and the
definitions of saving and investment. By rearranging the components of GDP for a closed economy,
investment equals income minus consumption minus government purchases. Adding together private
saving by households and public saving by government also equals income minus consumption minus
government purchases.
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CHAPTER 21 (9) | Economic Growth, the Financial System, and Business Cycles
2.4
Loanable funds are the money that households save and lend to businesses. Businesses demand
loanable funds to borrow money to fund new investment projects. Households supply loanable funds to
save money and earn interest for future years.
Problems and Applications
2.5 You would have to take the time and expense to gather information on the borrower and his
likelihood of repaying. Your funds would not be liquid. If you wanted the money back before the loan
was due, the borrower would not have to pay before the due date. Lastly, your money would not be
spread out across different investments to reduce risk.
2.6
Capital investment is a key factor for economic growth. A weak banking system in China makes
it difficult to channel saving (the supply of loanable funds) to firms that need to borrow funds for capital
investment.
2.7
A budget deficit shifts the supply of loanable funds to the left. As the supply curve for loanable funds
shifts to the left, the equilibrium real interest rate rises and the equilibrium quantity of loanable funds
falls.
2.8
a. Private saving: Sprivate = Y + TR – C – T = $11 trillion + $1 trillion - $8 trillion - $3 trillion =
$1 trillion
b. Public saving: Spublic = T – G – TR, but G not given. Use I = Sprivate + Spublic;
$2 trillion = $1 trillion + Spublic; Spublic = $1 trillion
c. Government purchases: Solve using Spublic = T – G – TR, or I = Y – C – G
G = $1 trillion
d. Government budget surplus = T – G – TR = $1 trillion
2.9
a. Private saving: Sprivate = Y + TR – C – T, but TR not given. Use I = Sprivate + Spublic
I = Y – C – G = $12 trillion - $8 trillion - $2 trillion = $2 trillion. Spublic = $−0.5 trillion, so
Sprivate = $2.5 trillion
b. Investment spending: I = $2 trillion
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489
c. Transfer payments: Spublic = T – G – TR; $−0.5 trillion = $2 trillion − $2 trillion – TR, TR =
$0.5 trillion
d. Government budget deficit = T – G – TR = –$0.5
2.10
S and I must drop by $0.5 trillion. I = S = Y – C – G. With no change in Y and C, an increase in
G must drop I and S by the same amount.
2.11
a. A decrease in the supply of loanable funds.
b. The equilibrium quantity of loanable funds decreases.
c. The quantity of savings decreases as does the quantity of investment.
2.12
a. Both the equilibrium interest rate and the quantity of loanable funds increase.
b. The demand for loanable funds increased. For a given demand for loanable funds, an increase
in the interest rate does decrease the quantity of loanable funds demanded.
c. If the interest rate had remained at i1, the quantity of loanable funds demanded would have
increased from L1 to L3.
d. With the increase in the interest rate from i1 to i2, the quantity of loanable funds supplied
increase from L1 to L2.
2.13
An expansion will increase the expected profitability of new investment, which will increase the
demand for loanable funds. The equilibrium real interest and the quantity of loanable funds will both rise,
as will the quantity of saving and investment.
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CHAPTER 21 (9) | Economic Growth, the Financial System, and Business Cycles
2.14
An increase in business taxes will decrease the after-tax rate of return on investment projects,
which will decrease the demand for loanable funds. The equilibrium real interest rate and quantity of
loanable funds will both decrease, which will decrease the quantity of investment and the economy’s
future capital stock.
2.15
The federal budget surplus would increase the supply of loanable funds, which will decrease the
equilibrium real interest rate and increase the quantity of loanable funds. Saving and investment both rise.
CHAPTER 21 (9) | Economic Growth, the Financial System, and Business Cycles
491
2.16
The after-tax return to savers would rise, which would increase the supply of loanable funds. The
equilibrium real interest rate will fall, but the quantity of loanable funds would increase, as would the
quantity of saving and investment.
2.17 The pre-reform Scrooge saved nearly all of his large income, which increased the supply of loanable
funds, and helped increase the quantity of investment goods and, therefore, economic growth. Because the
post-reform Scrooge bought food for poor people, the productivity of those poor people would increase,
which would have a positive impact on economic growth. So, taking this consideration into account, it
becomes ambiguous whether the pre-reform or post-reform Scrooge was better for economic growth.
LEARNING OBJECTIVE
LEARNING OBJECTIVE 21.3: Explain what happens during a business cycle.
Review Questions
3.1
a.
b.
c.
d.
peak;
trough;
recession;
expansion
3.2
During an economic expansion, particularly near the end of the expansion, the inflation rate
typically increases, and during recessions the inflation rate typically decreases. The unemployment rate
rises during recessions and falls during expansions.
3.3
The recessions were more severe during the first half of the twentieth century than the second half.
Economists agree that the rising portion of services relative to manufactured goods in the economy and the
establishment of government transfer payments have lessened the severity of recessions. Economists
disagree on whether active federal government policies to stabilize the economy have done so.
Problems and Applications
492
CHAPTER 21 (9) | Economic Growth, the Financial System, and Business Cycles
3.4 Ford F-150 trucks, Kenmore refrigerators, and Caterpillar industrial tractors are durable goods and
would be expected to fluctuate more than real GDP during the business cycle.. McDonald’s Big Macs and
Huggies diapers are nondurable goods and would be expected to fluctuate less than real GDP.
3.5
As part of the federal government, the U.S. Department of Commerce could be pulled into
politics with the dating of recessions. They could come under pressure to set the start and end of the
recession to help the administration in power.
3.6
You should disagree with that statement. Real GDP itself is not a measure of economic growth,
which is the percentage change in real GDP from one year to the next. Despite the fact that $11.4 trillion
for real GDP in 2007 is a large number, economic growth might have been small or negative. To calculate
economic growth during 2007, we also need to know the value of real GDP in 2006.
3.7
People base their votes for president on a wide range of issues. The state of the economy at the
time of an election is one of the most important of these issues because of its effect on employment,
income growth and the prices of goods and services that voters buy. Some years ago, a pundit advised
future presidents to “get your recession out of the way early.” He meant that a recession that began in the
first two years of a president’s term in office (for example, Ronald Reagan was first elected in 1980 – the
U.S. economy experienced a serious recession in 1981-82) would be over by the time of the next election
when the economy would be in an economic expansion. In fact, President Reagan was re-elected by a
large margin in 1984. Presidents who run for re-election during a recession (for example, the U.S.
economy was in recession in the first part of 1980 when Jimmy Carter was campaigning for a second term
as president) have a difficult time convincing voters that the recession is not their fault. Presidents, much
like football coaches and baseball managers, get a disproportionate amount of credit or blame for events
that are not entirely under their control.
3.8
Your firm will most likely still be operating below capacity. Also, before rehiring workers you
will want to make sure that the increase in economic activity continues for a significant period.