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CHAPTER
10
Economic Growth, the Financial
System, and Business Cycles
Chapter Outline and
Learning Objectives
10.1 Long-Run Economic Growth
10.2 Saving, Investment, and the
Financial System
10.3 The Business Cycle
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Long-Run Economic Growth
10.1 LEARNING OBJECTIVE
Discuss the importance of long-run economic growth.
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
Learning Objective 10.1
Long-Run Economic Growth
Long-run economic growth The process by which rising
productivity increases the average standard of living.
FIGURE 10.1
The Growth in Real GDP
per Capita, 1900–2006
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
Learning Objective 10.1
Making
the
Connection
The Connection between
Economic Prosperity and Health
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
Annual Percent
Change
Year
Real GDP
Potential GDP
1999
$ 9,470
$ 9,281
2000
$ 9,817
$ 9,634
2001
$ 9,891
$ 9,991
2002
$10,049
$10,342
2003
$10,321
$10,677
Annual Percent Change in Real GDP:
((Current value – Prior Year Value) / Prior Year Value) x 100
Example: Annual Percent Change for real GDP from 1999 to 2000:
Average Percent Change from 1999 to 2003:
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
Learning Objective 10.1
Long-Run Economic Growth
Calculating Growth Rates and the Rule of 70
Number of years to double 
70
Growth rate
What Determines the Rate of Long-Run Growth?
Labor productivity The quantity
of goods and services that can be
produced by one worker or by one
hour of work.
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
What determines the rate of long-run growth?
Increases in real GDP per capita rely on increases in labor
productivity: the quantity of goods and services that can be
produced by one worker or by one hour of work.
Why can the average American consume eight times as many
goods and services now, as in 1900?
Because the average American produces eight times as many
goods and services in an hour now, as in 1900.
So most of the answer to “what determines the rate of long-run
growth” is the same as the answer to “what determines labor
productivity growth?”
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
Factors affecting labor productivity growth
Increases in capital per hour worked
Capital is manufactured goods that are used to produce other
goods and services.
The more capital a worker has available to use (including human
capital, the accumulated knowledge and skills workers possess),
the more productive he or she will be.
Technological change
Improvements in capital or methods to combine inputs into
outputs (i.e. new technologies) allow workers to produce more in
a given period of time.
The role of entrepreneurs here is critical, in pioneering new ways
to bring together the factors of production to produce better or
lower-cost products.
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
Learning Objective 10.1
Long-Run Economic Growth
Potential Real GDP
Potential GDP The level of
GDP attained when all firms are
producing at capacity.
Potential GDP rises when…
The growth in potential GDP in the U.S.
has been relatively steady at about
3.3%; that is, the potential to produce
final goods and services has been
growing in the U.S. at about this rate
over time.
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
Actual and potential GDP in the United States
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Figure 10.2
Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
Saving, Investment, and the Financial System
10.2 LEARNING OBJECTIVE
Discuss the role of the financial system in facilitating long-run economic
growth.
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
Learning Objective 10.2
Saving, Investment, and the Financial System
Financial system The system of
financial markets and financial
intermediaries through which firms
acquire funds from households.
An Overview of the Financial System
Financial markets Markets where financial
securities, such as stocks and bonds, are
bought and sold.
Financial intermediaries Firms, such as
banks, mutual funds, pension funds, and
insurance companies, that borrow funds from
savers and lend them to borrowers.
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
Three key services of the financial system
The financial system provides three key services:
Risk-sharing
Liquidity
Information
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
Learning Objective 10.2
Saving, Investment, and the Financial System
The Macroeconomics of Saving and Investment
Y = C + I + G + NX
Y=C+I+G
I=Y−C−G
Sprivate = Y + TR − C − T
Spublic= T − G − TR
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
Learning Objective 10.2
Saving, Investment, and the Financial System
The Macroeconomics of Saving and Investment
S = Sprivate
+
Spublic
or
S = (Y + TR − C − T) + (T − G − TR)
or
S=Y−C−G
So, we can conclude that total saving must equal total
investment:
S=I
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
Learning Objective 10.2
Saving, Investment, and the Financial System
The Market for Loanable Funds
Market for loanable funds The interaction
of borrowers and lenders that determines
the market interest rate and the quantity of
loanable funds exchanged.
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
Learning Objective 10.2
Making
the
Connection
Ebenezer Scrooge: Accidental
Promoter of Economic Growth?
Who was better for economic growth: Scrooge the
saver or Scrooge the spender?
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
The Business Cycle
10.3 LEARNING OBJECTIVE
Explain what happens during the business cycle.
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
Economic Growth, the Financial System,
and Business Cycles
Business cycle Alternating periods of
economic expansion and economic recession.
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.
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
The business cycle
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
The business cycle, 2005-2011
This figure shows the movements
in real GDP in the U.S. from 2005
to 2011.
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.
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
How do we known 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.
However 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
wholesale-retail trade.”
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Table 10.1 NBER-defined recessions since 1950
Length of
Peak
Trough
Recession
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
6 months
16 months
18 months
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
Making
the
Connection
Can a Recession Be a Good Time
for a Business to Expand?
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, computer chip maker Intel decided in early 2009 to
proceed with a $7 billion expansion of its U.S. factories.
Heavy equipment manufacturer Caterpillar acted similarly, expanding
in order “to meet the expected increase in customer demand”.
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
The effect of the business cycle on Boeing
Boeing makes aircraft—very much a durable good. So we expect
their sales to be strongly affected by recessions.
The charts show this prediction to be accurate—though Boeing
was less affected by the recession of 2007-2009 than we might
have expected; overseas demand remained strong in this period.
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
The effect of the business cycle on inflation—graph
(red bars indicate recession)
Notice that inflation tends to rise toward the end of an expansion,
and fall over the course of each recession.
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
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.
(red bars indicate recession)
Notice that
unemployment
often continues
to rise, even
after the end of
each recession.
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
Fluctuations in real GDP: 1900-2010
Figure 10.10
Annual fluctuations in real GDP were typically greater before 1950
than after 1950. Economists refer to this as the “Great Moderation”.
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
Learning Objective 10.3
The Business Cycle
What Happens during a Business Cycle?
Recessions Have Been Milder and the Economy Has Been
More Stable Since 1950
The Business Cycle Has
Become Milder
PERIOD
AVERAGE LENGTH
OF EXPANSIONS
AVERAGE LENGTH
OF RECESSIONS
1870-1900
26 months
26 months
1900-1950
25 months
19 months
1950-2001
61 months
9 months
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
Explaining the Great Moderation
Several factors help to explain the Great Moderation:
The increasing importance of services
Manufacturing (especially of durable goods) is more strongly
affected by recessions. The economy is based more on services
now, decreasing the effect of the business cycle on GDP.
The establishment of unemployment insurance
Before the 1930s, unemployment insurance and other
government transfer programs like Social Security did not exist.
These programs increase the ability of consumers to purchase
goods and services during recessions.
Active federal government stabilization policies
Increased stability of the financial system
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Chapter 21: Economic Growth, the Financial System, and Business Cycles
Explaining the Great Moderation
Several factors help to explain the Great Moderation:
The increasing importance of services
The establishment of unemployment insurance
Active federal government stabilization policies
Many, though not all, economists believe that active government
policies to lengthen expansions and minimize the effects of
recessions have had the desired effect. The debate over the role
of government in this way became particularly intense during the
recession of 2007-2009.
Increased stability of the financial system
The severity of the Great Depression of the 1930s was in part
caused by instability in the financial system; similar instability
exacerbated the recession of 2007-2009. Returning to
macroeconomic stability will require a stable financial system.
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