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© 2007 Thomson South-Western
In this section,
look for the answers to these
questions:
• Why does productivity matter for living standards?
• What determines productivity and its growth rate?
• How can public policy affect growth and living
standards?
• Financial System
• Market for Loanable Funds
• Govt. impacts to interest rates
•1
© 2007 Thomson South-Western
A typical family with all their possessions
in the U.K., an advanced economy
• GDP per capita:
• Life expectancy:
• Adult literacy:
$35,580
79 years
99%
© 2007 Thomson South-Western
A typical family with all their
possessions in Mali, a poor country
• GDP per capita:
• Life expectancy:
• Adult literacy:
$1,130
50 years
46%
© 2007 Thomson South-Western
Incomes and Growth Around the World
Questions:
• Why are some countries richer than others?
• Why do some countries grow quickly while
others seem stuck in a poverty trap?
• What policies may help raise growth rates and
long-run living standards?
•4
© 2007 Thomson South-Western
Productivity
• Recall one of the Ten Principles from Chap. 1:
A country’s standard of living depends
on its ability to produce g&s.
• This ability depends on
productivity, the average quantity of g&s
produced per unit of labor input.
•5
© 2007 Thomson South-Western
Why Productivity Is So Important
• When a nation’s workers are very productive, real
GDP is large and incomes are high.
• When productivity grows rapidly, so do living
standards.
• What, then, determines productivity and its growth
rate?
• Human capital (H):
the knowledge and skills workers acquire through
education, training, and experience
• Productivity is higher when the average worker has
more human capital (education, skills, etc.).
•6
© 2007 Thomson South-Western
Productivity / Growth Rate Determinants
• Recall: The stock of equipment and structures used to
produce g&s is called [physical] capital, denoted K.
• Productivity is higher when the average worker has
more capital (machines, equipment, etc.).
• Natural resources (N): the inputs into production that
nature provides, e.g., land, mineral deposits
• Some countries are rich because they have abundant
natural resources (e.g., Saudi Arabia has lots of oil).
• But countries need not have much N to be rich
(e.g., Japan imports the N it needs).
•7
© 2007 Thomson South-Western
Technological Knowledge
• Technological knowledge: society’s
understanding of the best ways to produce g&s
• Technological progress does not only mean
a faster computer, a higher-definition TV,
or a smaller cell phone.
• It means any advance in knowledge that boosts
productivity (allows society to get more output
from its resources).
• E.g., Henry Ford and the assembly line.
•8
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Factor of Production Identification
Identify factors of production seen in this photo.
© 2007 Thomson South-Western
ACTIVE LEARNING
1
Discussion Question
Which of the following policies do you think would
be most effective at boosting growth and living standards
in a poor country over the long run?
a. Offer tax incentives for investment by local firms
b.
”
”
”
”
”
by foreign firms
c. Give cash payments for good school attendance
d. Crack down on govt corruption
e. Restrict imports to protect domestic industries
f. Allow free trade
g. Give away condoms
© 2007 Thomson South-Western
ECONOMIC GROWTH
AND PUBLIC POLICY
Next, we look at the ways
public policy can affect
long-run growth in productivity
and living standards.
© 2007 Thomson South-Western
Saving and Investment
• We can boost productivity by increasing K,
which requires investment.
• Since resources scarce, producing more capital
requires producing fewer consumption goods.
• Reducing consumption = increasing saving.
This extra saving funds the production of
investment goods. (More details in the next chapter.)
• Hence, a tradeoff between current and future
consumption.
© 2007 Thomson South-Western
The Production Function & Diminishing Returns
•If workers
•Output per
have little
K,
worker
giving
them more
(productivity)
increases their
productivity a lot.
•If workers already
have a lot of K,
giving them more
increases
productivity
fairly little.
•Y/
L
•K/
L
•Capital per worker
© 2007 Thomson South-Western
Additional factors that can help
development
• Foreign direct investment / foreign portfolio
investment
• Education and R&D
• Health and Nutrition
• Property Rights and Political Stability
• Trade
•
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What about Population Growth?
…may affect living standards in 3 different ways:
1.Stretching natural resources (ie. Malthus)
2.Diluting the capital stock
3.Promoting tech. progress
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Saving, Investment, and the Financial
System
• The financial system consists of the group of
institutions in the economy that help to match
one person’s saving with another person’s
investment.
• It moves the economy’s scarce resources from
savers to borrowers.
© 2007 Thomson South-Western
FINANCIAL INSTITUTIONS IN THE U.S.
ECONOMY
• The financial system is made up of financial
institutions that coordinate the actions of
savers and borrowers.
• Financial institutions can be grouped into two
different categories:
• Financial markets (ie. Stock or Bond Markets)
• Financial intermediaries (ie. Banks or Mutual
Funds)
© 2007 Thomson South-Western
FINANCIAL INSTITUTIONS IN THE U.S.
ECONOMY
• Financial markets are the institutions through
which savers can directly provide funds to
borrowers.
• Financial intermediaries are financial
institutions through which savers can
indirectly provide funds to borrowers.
© 2007 Thomson South-Western
THE MARKET FOR LOANABLE FUNDS
• Financial markets coordinate the economy’s
saving and investment in the market for
loanable funds.
• The market for loanable funds is the market in
which those who want to save supply funds
and those who want to borrow to invest
demand funds.
© 2007 Thomson South-Western
Supply and Demand for Loanable Funds
• Loanable funds refers to all income that people
have chosen to save and lend out, rather than
use for their own consumption.
• The supply of loanable funds comes from
people who have extra income they want to
save and lend out.
• The demand for loanable funds comes from
households and firms that wish to borrow to
make investments.
© 2007 Thomson South-Western
Supply and Demand for Loanable Funds
• Interest rate
• the price of the loan
• the amount that borrowers pay for loans and the
amount that lenders receive on their saving
• in the market for loanable funds, the real interest
rate
© 2007 Thomson South-Western
Supply and Demand for Loanable Funds
• Financial markets work much like other
markets in the economy.
• The equilibrium of the supply and demand for
loanable funds determines the real interest rate.
The real interest rate:
• corrected for inflation
• the rate of growth in the purchasing power of a deposit
or debt
© 2007 Thomson South-Western
Figure 1 The Market for Loanable Funds
•Interest
•Rate
•Supply
•5%
•Demand
•0
•$1,200
•Loanable Fund
•(in billions of dolla
© 2007 Thomson South-Western
Supply and Demand for Loanable Funds
• Government Policies That Affect Saving and
Investment
• Taxes and saving
• Taxes and investment
• Government budget deficits and surpluses
© 2007 Thomson South-Western
Policy 1: Saving Incentives
• Taxes on interest income substantially reduce
the future payoff from current saving and, as a
result, reduce the incentive to save.
• A tax decrease increases the incentive for
households to save at any given interest rate.
• The supply of loanable funds curve shifts right.
• The equilibrium interest rate decreases.
• The quantity demanded for loanable funds
increases.
© 2007 Thomson South-Western
Figure 2 An Increase in the Supply of
Loanable Funds
•Interest
•Rate
•Supply, •S1
•S2
•1. Tax incentives for
•saving increase the
•supply of loanable
•fund•s . . .
•5%
•4%
•2.•. . . which
•reduces the
•equilibrium
•interest rat•e . . .
•Demand
•0
•$1,200
•$1,600
•Loanable Funds
•(in billions of dollars)
•3.•. . . and raises the equilibrium
•quantity of loanable funds.
© 2007 Thomson South-Western
Policy 1: Saving Incentives
• If a change in tax law encourages greater
saving, the result will be lower interest rates
and greater investment.
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Policy 2: Investment Incentives
• An investment tax credit increases the incentive
to borrow.
• Increases the demand for loanable funds.
• Shifts the demand curve to the right.
• Results in a higher interest rate and a greater
quantity saved.
• If a change in tax laws encourages greater
investment, the result will be higher interest
rates and greater saving.
© 2007 Thomson South-Western
Figure 3 Investment Incentives Increase
the Demand for Loanable Funds
•Interest
•Rate
•Supply
•1. An investment
•tax credit
•increases the
•demand for
•loanable fund •s . . .
•6%
•5%
•2. •. . . which
•raises the
•equilibrium
•interest rate . . .
•D2
•Demand, •D1•
•0
•$1,200
•$1,400
•Loanable Funds
•(in billions of dollars)
•3. •. . . and raises the equilibrium
•quantity of loanable funds.
© 2007 Thomson South-Western
Policy 3: Government Budget Deficits and
Surpluses
• When the government spends more than it
receives in tax revenues, the short fall is called
the budget deficit.
• The accumulation of past budget deficits is
called the government debt.
© 2007 Thomson South-Western
Policy 3: Government Budget Deficits and
Surpluses
• Government borrowing to finance its budget
deficit reduces the supply of loanable funds
available to finance investment by households
and firms.
• This fall in investment is referred to as
crowding out.
• The deficit borrowing crowds out private borrowers
who are trying to finance investments.
© 2007 Thomson South-Western
Policy 3: Government Budget Deficits and
Surpluses
• A budget deficit decreases the supply of
loanable funds.
• Shifts the supply curve to the left.
• Increases the equilibrium interest rate.
• Reduces the equilibrium quantity of loanable
funds.
© 2007 Thomson South-Western
Figure 4: The Effect of a Government
Budget Deficit
•Interest
•Rate
•S2
•Supply, •S1
•1. A budget deficit
•decreases the
•supply of loanable
•fund•s . . .
•6%
•5%
•2.•. . . which
•raises the
•equilibrium
•interest rat•e . . .
•Demand
•0
•$800
•$1,200
•Loanable Funds
•(in billions of dollars)
•3.•. . . and reduces the equilibrium
•quantity of loanable funds.
© 2007 Thomson South-Western
Policy 3: Government Budget Deficits and
Surpluses
• When government reduces national saving by
running a deficit, the interest rate rises and
investment falls.
• A budget surplus increases the supply of
loanable funds, reduces the interest rate, and
stimulates investment.
© 2007 Thomson South-Western