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Chapter 10: Economic Growth, the Financial System, and Business Cycles Yulei Luo SEF of HKU February 5, 2017 Learning Objectives 1. Discuss the importance of long-run economic growth. 2. Discuss the role of the …nancial system in facilitating long-run economic growth. 3. Explain what happens during a business cycle. I One determinant of economic growth is the ability of …rms to expand their operations, buy additional equipment, train workers, and adopt new technologies. I To carry out these activities, …rms must acquire funds from households, either directly through …nancial markets— such as the stock and bond markets— or indirectly through …nancial intermediaries— such as banks. I Financial markets and …nancial intermediaries together comprise the …nancial system. In this chapter, we present an overview of the …nancial system and see how funds ‡ow from HHs to …rms through the market for loanable funds. I We also begin to explore two key aspects of macroeconomics: the long-run growth that has steadily raised living standards in the U.S. and the short-run ‡uctuations of the business cycle. I Long-run economic growth: The process by which rising productivity increases the standard of living (henceforth, SOL) of the typical person. I Financial system: Composed by (1) …nancial markets (the stock and bond markets) and (2) …nancial intermediaries (banks). I Business cycle: Alternating periods of economic expansion and economic recession. Features of Economic Growth in the U.S. 1. The values in the above …gure are measured in prices of 2005, so they represent constant amount of purchasing power. 2. The average American in 2010 could purchase more than 8 times as many G&S as the average American in 1900 ($42, 200 vs. $5, 600). 3. This increase in real GDP actually understates the true increase in the SOL of American in 2008 compared with 1900. Many of G&S today are not available in 1900. 4. Although GDP is not the perfect measure for happiness, economists rely heavily on comparisons of real GDP per person and ignore the e¤ects of the levels of crime, pollution, and so on on a person’s happiness because real GDP is the best means of the economic performance. Long-Run Economic Growth When we speak of long-run economic growth, we mean the process by which rising productivity increases the average standard of living. The most commonly used measure of this average standard of living is real GDP per capita: the amount of production in the economy, per person, adjusted for changes in the price level. Figure 10.1 The growth in real GDP per capita, 1900-2012 As the chart shows, real GDP per capita has risen more than eightfold since 1900; the average American can buy more than eight times as many goods and services now as in 1900. © Pearson Education Limited 2015 5 of 44 Making the Connection Economic Prosperity and Health Economic prosperity and health go hand-in-hand: richer nations can devote more resources to improving the health of their citizens, and healthier citizens are more productive. While growth in real GDP per capita is an important measure of our improvement, another important measure is the increase in our lifespans; these have also increased markedly over the last century. © Pearson Education Limited 2015 6 of 44 Making the Connection Economic Prosperity and Health Another good measure of our economic prosperity is the amount of time we can spend on “leisure”. As our lifespan grows, we can spend more time on leisure; and also, as we grow more productive, we can devote less time to work, and hence more to leisure. The chart shows estimates from Nobel Prize-winner Robert Vogel, who predicts that improvements in productivity and lifespan will continue to improve the lives of Americans over the coming decades. © Pearson Education Limited 2015 7 of 44 Connection between Economic Prosperity and Health 1. There is a link between health and economic growth. As people became stronger and healthier, they also became more productive. Today, development economists have put increasing emphasis on the need for low-incomoe countries to reduce disease and increase nutrition if they are to experience growth. 2. The state of human physiology will improve as technology advances. Technology advance will reduce the average number of hour worked per day and the number of years of working in the paid workforce. 3. Discretionary hours (except sleeping, eating, and bathing) are divided between paid work and leisure. 4. Not only will technology and economic growth allow people in the near future to live longer lives, but a much smaller fraction of those lives will need to be spent at paid work. Calculating Growth Rates and the Rule of 70 I For longer periods of time, we use the average annual growth rate (AAGR). For example, real GDP in the US equals $2, 006 billion in 1950 and $13, 312 in 2008, then the AAGR during this 58-year period is 3.3%: 2, 006(1 + X )58 = 13, 312 =) X = 3.3%. I (1) For shorter periods of time, we use the following procedure. E.g., if real GDP grew by 2.7% in 2006, 2.1% in 2007, and 0.4% in 2008, the AAGR for the period of 2006 2008 was 2.7% + 2.1% + 0.4% = 1.7%. 3 (2) I (Conti.) One way to judge how rapidly real GDP per person is growing is to calculate the number of years it would take to double: Number of years to double = 70 . Growth rate (3) I For example, if real GDP per capita is growing at a rate of 5% per year, it will double in 70/5 = 14 years. If real GDP per capita is growing at 2% per year, it will take 70/2 = 35 years to double. I Conclusion: Small di¤erences in growth rates can have large e¤ects on how rapidly the SOL increase. I Note that the rule of 70 can also be applied to growth in any variable. What Determines the Rate of Long-Run Growth? I The basic idea: Increases in real GDP per capita depend on increases in labor productivity. (We’ll explore the sources of growth in more detail in Chapter 10.) I Labor productivity (LP): The quantity of G&S that can be produced by one worker or by one hour of work. I I Economists usually measure LP as output per hour of work to avoid ‡uctuations in the length of the workday and in the fraction of the population employed. Two key factors determine LP: 1. The quantity of capital per hour worked 2. The level of technology. Increases in capital per hour worked I Capital (also called physical capital): Manufactured goods that are used to produce other G&S; examples of capital are computers, factory buildings, machine tools, warehouses, and trucks. I I The total amount of physical capital 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: The accumulated knowledge and skills that workers acquire from education and training, or from their life experiences. I Workers with college education have more skills and are more productive than workers with only high school degrees. Technological change I Technology: The processes a …rm uses to turn inputs into outputs of G&S. And it is more important than capital per hour worked for economic growth. I Technological change: An increase in the quantity of output …rms can produce using a given quantity of inputs. I I It could come from many sources (e.g., rearrange the layout of a retail store.) Most technological change is embodied in new machinery, equipment, or software. I (Conti.) Just accumulating more inputs (labor, capital, and natural resources) will not ensure economic growth unless technological change also occurs. I Entrepreneurs are important in implementing technological changes. (An entrepreneur is someone who operates a business, bringing together the factors of production to produce G&Ss. I In market economies, entrepreneurs make the crucial decisions about: I I Whether or not to introduce new technology to produce better or lower-cost products. Whether to allocate the …rm’s resources to R&D that can result in new technologies. Government Policies I An additional requirement for growth is that the government provides secure rights to private property: A market system cannot function unless rights to private property are secure. I In addition, establishing an independent court system that enforces contracts between private individuals, as well as an e¢ cient …nancial system and systems of education, transportation, and communication are also helpful. I I I Economic Growth depends on the ability of …rms to expand their operations (output), buy additional equipment (capital), train workers (human capital, labor productivity), and adopt new technologies. Firms can …nance some of these activities from retained earnings, which are pro…ts that are reinvested in the …rm rather than paid to the …rm’s owners. For many …rms, retained earnings are not su¢ cient to …nance the expansion. Firms can acquire funds from HHs, either directly through …nancial markets (e.g., the stock and bond markets) or indirectly through …nancial intermediaries (e.g., banks). Financial system (FS): The system of …nancial markets (Markets where …nancial securities, such as stocks and bonds, are bought and sold) and …nancial intermediaries (Firms, such as banks, mutual funds, pension funds, and insurance companies, that borrow funds from savers and lend them to borrowers.) I I The FS channels funds from savers to borrowers; and channels returns on the borrowed funds back to savers. Potential GDP Potential GDP refers to the level of real GDP attained when all firms are operating at capacity. Capacity here refers to “normal” hours and a “normal” sized workforce. • Potential GDP rises when the labor force expands, when a nation acquires more capital stock, or when new technologies are created. The growth in potential GDP in the U.S. has been relatively steady at about 3.2%; that is, the potential to produce final goods and services has been growing in the U.S. at about this rate over time. The recession of 2007-2009 resulted in a wider than usual gap between potential and actual GDP, as the next slide illustrates. © Pearson Education Limited 2015 13 of 44 Actual and Potential GDP in the United States Figure 10.2 © Pearson Education Limited 2015 Actual and potential GDP 14 of 44 An Overview of the Financial System I Stocks are …nancial securities that represent partial ownership of a …rm. I Bonds are …nancial securities that represent promises to repay a …xed amount of funds. I Financial intermediaries, such as banks, mutual funds, pension funds, and insurance companies, act as go-betweens for borrowers and lenders. I Mutual funds sell shares to savers and then use the funds to buy a portfolio of stocks, bonds, mortgages, and other …nancial securities. In addition to matching HHs that have excess funds with …rms who want to borrow funds, the FS provides three key services: 1. Risk sharing: Risk is the chance that the value of a …nancial security will change relative to what you expect. FS allows savers to spread their money among many …nancial investments. 2. Liquidity: is the ease with which a …nancial security can be exchanged for money. The …nancial system provides the service of liquidity by providing savers with markets in which they can sell their holdings of …nancial securities. 3. Information: FS provides a service of the collection and communication of information, or facts about borrowers and expectations about asset returns. E.g., the expectation of higher future pro…ts of a …rm would boost the prices of the …rm’s stock and bonds. The Macroeconomics of Saving and Investment I When …rms use funds (through FS from saving) to purchase machinery, factories, and o¢ ce buildings, they are engaging in investment. I A key point is that the total value of saving in the economy must equal to the total value of investment: I I We can use some relationships from national income accounting, the methods the BEA uses to keep track of GDP, or total production and total income in the economy. The GDP identity, Y = C + I + G + NX , implies that: total investment: I = Y C G; (4) note that in a closed economy (NX = 0). I (Conti.) Private saving is equal to what HHs retain of their income (Y ) (HHs receive income for supplying the factors of production to …rms. This portion of household income is equal to Y .) after purchasing G&S (C ) and paying taxes (T ). I HHs also receive income from gov. in the form of transfer payments (TR) (including UI and SS payments). I The gov. also engages in saving. Public saving equals to the amount of tax revenue the gov retains after paying for gov purchases and making transfer payments to HHs. I = Sprivate + Spublic S = (Y + TR C T ) + (T + G S = Y C G S I (5) TR ) (6) (7) Implications: I Total saving must equal to total investment: S = I. I When the gov spends the same amount that it collects in taxes, G + TR = T , there is a balanced budget. (8) (9) Implications I When G + TR > T , there is a budget de…cit, which means that public saving is negative (dissaving). When the gov runs a budget de…cit, the US Department of Treasury sells bonds to …nance the gap between taxes and spending. Negative saving is also known as dissaving. I Similarly, when G + TR < T , there is a budget surplus. Holding constant all other factors, investment is highest in the economy where there is a budget surplus. Making Ebenezer Scrooge: Accidental Promoter of Economic Growth? the Connection In Charles Dickens’ A Christmas Carol, Ebenezer Scrooge initially spends little. In the book, this is portrayed negatively, but is this really fair? • By declining to consume, Scrooge elects to save. Society’s resources can then be set toward investment, increasing productive capacity and hence future consumption. By the end of the story, Scrooge starts to spend his wealth. While this encourages current production, society was probably better served—and achieved stronger growth—when Scrooge chose to save instead. © Pearson Education Limited 2015 22 of 44 The Market for Loanable Funds I We can think of the …nancial system as being composed of many markets through which funds ‡ow from lenders to borrowers: the market for certi…cates of deposit at banks (COD), the markets for stocks and bonds, the market for mutual fund shares, and so on. I For simplicity, we combine these markets into a single market for loanable funds. I Market for loanable funds: The interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged. I We can now use the market for loanable funds to analyze the impacts of a government budget de…cit. I Crowding out: A decline in private expenditures as a result of an increase in government purchases. The Market for Loanable Funds Firms borrow loanable funds from households. They borrow more when households demand a lower return on their money—a lower real interest rate. Households supply loanable funds to firms. They provide more when firms offer them a greater reward for delaying consumption—a higher real interest rate. Governments, through their saving or dissaving, affect the quantity of funds that “pass through” to firms. © Pearson Education Limited 2015 Figure 10.3 The market for loanable funds 24 of 44 An Increase in the Demand for Loanable Funds Suppose that technological change occurs, so that investments become more profitable for firms. This will increase the demand for loanable funds. The real interest rate will rise, as will the quantity of funds loaned. Figure 10.4 © Pearson Education Limited 2015 An increase in the demand for loanable funds 25 of 44 Crowding Out in the Market for Loanable Funds Suppose the government runs a budget deficit. To fund the deficit, it sells bonds to households, decreasing the supply of funds available to firms. This raises the equilibrium real interest rate, and decreases the funds loaned to firms. • This is referred to as crowding out: the decline in private expenditures as a result of increases in government purchases. © Pearson Education Limited 2015 Figure 10.5 The effect of a budget deficit on the market for loanable funds 26 of 44 How Important Is Crowding Out? I In practice, the e¤ect of government budget de…cits and surpluses on the equilibrium interest rate is relatively small. I I How small? According to one study, increasing borrowing by 1% of GDP would increase the real interest rate 0.003 points. Why would the e¤ect be so small? I Interest rates are in‡uenced by global markets, so even a few hundred billion dollars is a relatively minor amount. The E¤ects of Consumption Tax I Consider someone who put his savings in a CD at an IR of 4% and whose tax rate is 25%. Under an income tax, the after-tax return is 3%. Under a consumption tax, income that is saved is not taxed, so the return is 4%. I Hence, moving to a consumption tax would increase the return to savings, causing the supply of loanable funds to increase, i.e., the supply curve shifts to the right. I It would then reduce the equilibrium IR and increase both saving and investment. Because investment increases, the capital stock and the quantity of capital per hour will grow and the rate of EG should increase. Summary of the Loanable Funds Model Table 10.1 © Pearson Education Limited 2015 Summary of loanable funds model 28 of 44 Summary of the Loanable Funds Model—continued Table 10.1 © Pearson Education Limited 2015 Summary of loanable funds model 29 of 44 Some Basic Business Cycle De…nitions I Real GDP per capita did not increase every year during this century. (E.g., in the 1930s, real GDP per capita fell for several years.) A related question is that what accounts for these ‡uctuations in the long-run upward trend. I A business cycle (BC) consists of alternating periods of expanding and contracting economic activity. I Because real GDP is the best measure of economic activity, the BC is usually illustrated using the movements in real GDP. I During the expansion phase of the BC, production, employment, and income are all increasing. I (Conti.) The period of expansion ends with a BC peak. I Following the peak, production, employment, and income decline as the economy enters the recession phase of the cycle. I The recession comes to an end with a BC trough, after which another expansion begins. An Idealized Business Cycle While real GDP per capita has risen about eight-fold since the start of the 20th century, it has not risen consistently every year. Since at least the early 19th century, the American economy has experienced alternating periods of expanding and contracting economic activity. The figure shows a typical idealized path for real GDP— rising, falling, then rising again. The phases of rising are known as expansion; the periods of falling are recessions. We refer to the points at which the economy changes from one phase to the other as peaks or troughs, respectively. © Pearson Education Limited 2015 Figure 10.6a The business cycle: an idealized business cycle 31 of 44 An Actual Business Cycle This figure shows the movements in real GDP in the U.S. from 2006 to 2013. The period of recession starting in late 2007 and ending in mid 2009 was the longest and most severe since the Great Depression of the 1930s, prompting some to refer to it as the Great Recession. Real GDP growth after this recession has been slower than is typical at the start of a business cycle expansion. © Pearson Education Limited 2015 Figure 10.6b The business cycle: movements in real GDP, 2006-2013 32 of 44 How Do We Know When the Economy Is in a Recession? The federal government does not define when a recession starts or ends. • The typical media definition of a recession is “two consecutive quarters of declining real GDP.” Length of Most economists defer to the judgment of the National Bureau of Economic Research: • “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 wholesaleretail trade.” Peak Trough 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 July 1981 November 1982 July 1990 March 1991 8 months March 2001 November 2001 8 months December 2007 June 2009 Table 10.2 © Pearson Education Limited 2015 Recession 6 months 16 months 18 months The U.S. business cycle 33 of 44 Making Can a Recession Be a Good Time to Expand? the Connection Historically, recessions have generally been followed by periods of strong economic growth. • Some firms take advantage of the low real interest rates that typically accompany a recession to make investments by expanding productive capacity, effectively betting that the growth will justify their investments. For example, VF Corporation (the largest apparel maker in the world, including brands such as North Face, Timberland, and Wrangler) decided to open 89 new stores in 2008 and 70 in 2009. • By 2013, the company’s sales and profits continued to increase, making their decision look very smart. © Pearson Education Limited 2015 34 of 44 When Do We Know When the Economy is in a Recession? I The federal government produces many statistics that make it possible to monitor the economy. However, most economists accept the decisions of the Business Cycle Dating Committee of the NBER, a private research group. I Although writers for newpapers and magazines often de…ne a recession as two consecutive quarters of declining real GDP, the NBER has a broader de…nition: De…nition A recession is a signi…cant 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 NBER is slow in announcing business cycle dates because it takes time to gather and analyze economic statistics. What Happens During a Business Cycle? I Each business cycle is di¤erent, but most BCs share certain characteristics: I I I I As the economy nears the end of an expansion, interest rates usually are rising, and the wages usually are rising faster than prices. As a result, the pro…ts of …rms will be falling. Toward the end of expansion both HHs and …rms will have substantially increased their debts due to the borrowing they undertake to help …nance their spending during the expansion. A recession will often begin with a decline in spending (1) by …rms on capital goods (machinery, equipment, etc.) or (2) by HHs on new houses and consumer durables (furniture and auto). When a recession hits, workers reduce spending due to expectations about their current and future incomes decreasing. I (Conti.) As spending declines, …rms selling these goods will …nd their sales declining. Consequently, …rms cut back on production and begin to lay o¤ workers. Rising unemployment and falling pro…ts reduce income, which leads to further declines in spending. I As the recession continues, economic conditions gradually improve. The declines in spending eventually come to an end; HHs and …rms begin to reduce their debts, thereby increasing their ability to spend; and interest rates declines, making it more likely that they will borrow to …nance new spending. I Firms begin to increase their spending on capital goods as they anticipate the need for additional production during next expansion. Increased spending by HHs on consumer durables and by businesses on capital goods will …nally terminate the recession and begin the next expansion. The E¤ect of the BC on Durables and the Boeing Example I Durables are goods that are expected to last for 3 or more years. I I I Nondurables are goods that are expected to last for fewer than three years. I I I Consumer durables include furniture, appliances, autos. Producer durables include machine tools, electronic generators, and commercial airplanes. Consumer nondurables include food and clothing. Durables are a¤ected more by the BC than are nondurable. During a recession, workers reduce spending if they lose jobs, fear losing jobs, or su¤er wage cuts. Because they can continue to use their existing durables, they are more likely to postpone spending on durables like automobiles. Similarly, …rms often cut back on purchases of producer durables during a recession. In each recession, airlines su¤ered declines in ticket sales and cut back on purchases of aircraft. Consequently, Boeing su¤ered sharp declines in sales. The Effect of the Business Cycle on Whirlpool Whirlpool makes household appliances—durable goods. So we expect their sales to be strongly affected by recessions. The charts show that the entire household appliance industry was particularly hard-hit by the recession of 2007-2009. © Pearson Education Limited 2015 Figure 10.7 The effect of the business cycle on Whirlpool. (a) Movements in real GDP, (b) Movements in the real value of manufacturers’ sales of household appliances 36 of 44 The e¤ect of the BC on the In‡ation Rate I During economic expansions the in‡ation rate usually increases, particularly near the end of the expansion, and during recessions the in‡ation rate usually decreases. I Recessions have consistently had the e¤ect of lowering the in‡ation rate. I I During an expansion, spending by businesses and HHs is strong and producers …nd it easier to raise prices. As spending declines during a recession, it is more di¢ cult for …rms to sell their products and they are likely to increase prices less. The E¤ect of the BC on the Unemployment Rate I Recessions cause the in‡ation rate to fall, but they cause the unemployment rate to increase. As …rms see their sales decline, they begin to reduce production and lay o¤ workers. I The unemployment rate continued to rise even after the end of recession. This typical pattern is due to two factors: 1. Even if employment begins to increase as the recession ends, it may be increasing more slowly than the growth in the labor force resulting from population growth. 2. Firms continue to operate well below their capacity even after a recession has ended; consequently, …rms may not hire back all the workers they laid o¤. The Effect of Recessions on the Inflation Rate Notice that inflation tends to rise toward the end of an expansion and fall over the course of each recession. © Pearson Education Limited 2015 Figure 10.8 The effect of recessions on the inflation rate 38 of 44 The Effect of the Business Cycle on Unemployment As firms see their sales start to fall in a recession, they generally reduce production and lay off workers. Notice that unemployment often continues to rise after the end of each recession. © Pearson Education Limited 2015 Figure 10.9 How recessions affect the unemployment rate 39 of 44 Fluctuations in Real GDP Annual fluctuations in real GDP were typically greater before 1950 than after 1950. Economists refer to this as the “Great Moderation”. © Pearson Education Limited 2015 Figure 10.10 Fluctuations in real GDP, 1900-2012 40 of 44 Is the “Great Moderation” Over? The length and severity of the recession of 2007-2009 has made some economists and policymakers wonder if we would return to the post-1950 pattern of long expansions and short, mild recessions. Average Length of Expansions Average Length of Recessions 1870-1900 26 months 26 months 1900-1950 25 months 19 months 1950-2009 61 months 11 months Period Table 10.3 Until 2007, the business cycle had become milder To judge whether this Great Moderation is over, it is useful to consider why has occurred at all and consider what if anything has fundamentally changed. © Pearson Education Limited 2015 41 of 44 Why Is the Economy More Stable? I The increasing importance of services (medical care or investment advice) and the declining importance of goods. Manufacturing production ‡uctuates more than the production of services. I The establishment of UI and other gov. transfer programs that provide funds to the unemployed. This additional spending may have helped to shorten recessions. Before the 1930s, unemployment insurance and other government transfer programs like Social Security did not exist. I Active federal gov. policies to stabilize the economy. The US gov was more active after the great depression. Fiscal and Monetary policies. I The increased stability of the …nancial system. Common Misconceptions to Avoid I Economists often have di¤erent terms to describe a variable and changes in that variable: Real GDP vs. economic growth rate. Price level vs. in‡ation. I “Savings” is composed of both private and public savings; it is easy to forget about the latter. I A “trough” is the end of a recession— the lowest point GDP obtains before beginning to rise again. Don’t confuse “trough” and “recession”. I Recessions do not a¤ect all …rms equally.