PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25
Comparing Economies Across Time and Space *Krugman
U.S. Real GDP per Capita *Krugman
Income Around the World *Krugman
Rule of 70 The Rule of 70 tells us that the time it takes a variable that grows gradually over time to double is approximately 70 divided by that variable s annual growth rate. *Krugman
Average Annual Growth Rates of Real GDP per Capita, 1975 2003 *Krugman
The Sources of Long-Run Growth - Definitions: Labor productivity Physical capital Human capital Technology *Krugman
*Productivity refers to the amount of goods and services produced for each hour of a worker s time. *A nation s standard of living is determined by the productivity of its workers *Living standards, as measured by real GDP per person, vary significantly among nations The poorest countries have average levels of income that have not been seen in the United States for many decades. *Annual growth rates that seem small become large when compounded for many years. *Compounding refers to the accumulation of a growth rate over a period of time. Productivity plays a key role in determining living standards for all nations in the world.
Economists often use a PRODUCTION FUNCTION to describe the relationship between the quantity of inputs used in production and the quantity of output from production. Y = quantity of output Y = A F(L, K, H, N) A = available production technology L = quantity of labor K = quantity of physical capital H = quantity of human capital N = quantity of natural resources F( ) is a function that shows how the inputs are combined. A production function has constant returns to scale if, for any positive number x, xy = A F(xL, xk, xh, xn) That is, a doubling of all inputs causes the amount of output to double as well.
Production functions with constant returns to scale have an interesting implication. Setting x = 1/L, Y/ L = A F(1, K/ L, H/ L, N/ L) Where: Y/L = output per worker K/L = physical capital per worker H/L = human capital per worker N/L = natural resources per worker The preceding equation says that productivity (Y/L) depends on physical capital per worker (K/L), human capital per worker (H/L), and natural resources per worker (N/L), as well as the state of technology, (A).
Accounting for Growth: The Aggregate Production Function The aggregate production function is a hypothetical function that shows how productivity (real GDP per worker) depends on the quantities of physical capital per worker and human capital per worker as well as the state of technology. *Krugman
Physical Capital and Productivity *Krugman
Average GDP Per Person grows about 2% per year. This means Average GDP Per Person doubles every 35 years.
Technological Progress and Productivity Growth *Krugman
Government Policies That Raise Productivity and Living Standards Encourage saving and investment. Encourage investment from abroad Encourage education and training. Establish secure property rights and maintain political stability. Promote free trade. Promote research and development Condition of the infrastructure. QuickTime and a TIFF (Uncompressed) decompressor are needed to see this picture. One way to raise future productivity is to invest more current resources in the production of capital.
Encourage saving and investment *As the stock of capital rises, the extra output produced from an additional unit of capital falls; this property is called diminishing returns. *Because of diminishing returns, an increase in the saving rate leads to higher growth only for a while. The catch-up effect refers to the property whereby countries that start off poor tend to grow more rapidly than countries that start off rich. In short, a higher savings rate increases productivity.
Encourage investment from abroad A capital investment that is owned and operated by a foreign entity is called foreign direct investment. (Ford Motor might build a car factory in Mexico) An investment that is financed with foreign money but operated by domestic residents is called foreign portfolio investment. (An American might buy stock in a Mexican corporation) In both cases, Americans provide the resources necessary to increase the stock of capital in Mexico.
Encourage investment from abroad When foreigners invest in a country, they expect a return on that investment. When Ford s car factory increases capital stock, it also increases the Mexican productivity and Mexican GDP. Ford can then take some of this additional income back to the U.S. in the form of profit. Remember that GDP is income earned within a country by residents and nonresidents, whereas GNP is income earned by residents both at home and abroad. Therefore, foreign investment in Mexico raises the income of Mexicans (GNP) by less than it raises the production in Mexico (GDP)
Encourage education and training For a country s long-run growth, education is at least as important as investment in physical capital. *In the United States, each year of schooling raises a person s wage, on average, by about 10 percent. *Thus, one way the government can enhance the standard of living is to provide schools and encourage the population to take advantage of them. An educated person might generate new ideas about how best to produce goods and services, which in turn, might enter society s pool of knowledge and provide an external benefit to others.
Encourage education and training EDUCATION is a positive externality. Dilemma: Wouldn t students from poor countries want to go to U.S. or other rich countries for education? What happens when they get there and they don t want to go back? One problem facing poor countries is the brain drain --the emigration of highly educated workers to rich countries. If human capital does have positive externalities, then this brain drain makes those people left behind poorer than they otherwise would be.
Establish secure property rights and maintain political stability Important for the price system to work is an economy-wide respect for property rights. the ability for people to exercise authority over resources they own. It is VERY important that the government enforce property rights in a free market society. In many developing countries contracts are difficult to enforce, and fraud goes unpunished. Doing business in these countries means that bribes and corruption are expected. This discourages international investment and domestic savings.
Encourage Free Trade Some of the poorest countries have tried to gain economic growth by using inwardoriented policies.aimed at raising the living standards by avoiding interaction with the world. Most economists, however, prefer the use of outward-oriented policies. Through the elimination of trade barriers. Using another country s technology and trading your goods for theirs acts as if the technology were in your own country.
Promote Research and Development Technology improves our standard of living: telephone, microwave oven, computer, and the automobile, all serve to improve the quality of life we enjoy. QuickTime and a TIFF (Uncompressed) decompressor are needed to see this picture. QuickTime and a TIFF (Uncompressed) decompressor are needed to see this picture. QuickTime and a TIFF (Uncompressed) decompressor are needed to see this picture. QuickTime and a TIFF (Uncompressed) decompressor are needed to see this picture. QuickTime and a TIFF (Uncompressed) decompressor are needed to see this picture.
Condition of Infrastructure Infrastructure refers to bridges, roads, ports, power plants.the foundation for our economy. A power grid that frequently shuts off electricity to homes and businesses or drought conditions because the dams can t hold enough water to get through the dry season are both examples of poor infrastructure. QuickTime and a TIFF (Uncompressed) decompressor are needed to see this picture. QuickTime and a TIFF (Uncompressed) decompressor are needed to see this picture. QuickTime and a TIFF (Uncompressed) decompressor are needed to see this picture. QuickTime and a TIFF (Uncompressed) decompressor are needed to see this picture. QuickTime and a TIFF (Uncompressed) decompressor are needed to see this picture. QuickTime and a TIFF (Uncompressed) decompressor are needed to see this picture.
Poor Countries Regulate Business the Most *Krugman
Success, Disappointment, and Failure *Krugman
Success, Disappointment, and Failure East Asian economies have done many things right and achieved very high growth rates. In Latin America, where some important conditions are lacking, growth has generally been disappointing. In Africa, real GDP per capita has declined for several decades, although there are some signs of progress now. The convergence hypothesis fits the data only when factors that affect growth, such as education, infrastructure, and favorable policies and institutions, are held equal across countries. *Krugman
Economics in Action: Are economies converging? *Krugman
SAVING AND INVESTMENT IN THE NATIONAL INCOME ACCOUNTS Taken from Mankiw Ch 26 Krugman Ch 26
The Savings Investment Spending Identity in a Closed Economy In a closed economy: GDP = C + I + G S Private = GDP + TR T C S Government = T TR G NS = S Private + S Government = (GDP + TR T C) + (T TR G) = GDP C G Hence, I = NS Investment spending = National savings in a closed economy *Krugman
Recall that GDP is both total income in an economy and total expenditure on the economy s output of goods and services: Y = C + I + G + N X
Some Important Identities Assume a closed economy one that does not engage in international trade: Y = C + I + G
Some Important Identities Now, subtract C and G from both sides of the equation: Y C G =I The left side of the equation is the total income in the economy after paying for consumption and government purchases and is called national saving, or just saving (S).
Some Important Identities Substituting S for Y - C - G, the equation can be written as: S = I
Some Important Identities National saving, or saving, is equal to: S = I S = Y C G S = (Y T C) + (T G)
The Meaning of Saving and Investment National Saving National saving is the total income in the economy that remains after paying for consumption and government purchases. Private Saving Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. Private saving = (Y T C)
The Meaning of Saving and Investment Public Saving Public saving is the amount of tax revenue that the government has left after paying for its spending. Public saving = (T G)
The Meaning of Saving and Investment Surplus and Deficit If T > G, the government runs a budget surplus because it receives more money than it spends. The surplus of T - G represents public saving. If G > T, the government runs a budget deficit because it spends more money than it receives in tax revenue.
The Meaning of Saving and Investment For the economy as a whole, saving must be equal to investment. S = I
Budget Surplus and Budget Deficit *Krugman
The Savings Investment Spending Identity in an Open Economy I = S Private + S Government + (IM X) = NS + KI (10) Investment spending = National savings + Capital inflow in an open economy *Krugman
The Savings-Investment Spending Identity in Open Economies: the United States and Japan 2003 *Krugman
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 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.
THE MARKET 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.
Supply and Demand for Loanable Funds 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.
Supply and Demand for Loanable Funds The interest rate is the price of the loan. It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving. The interest rate in the market for loanable funds is the real interest rate.
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.
Supply and Demand for Loanable Funds Government Policies That Affect Saving and Investment Taxes and saving Taxes and investment Government budget deficits *Mankiw
The Demand for Loanable Funds *Krugman
The Supply for Loanable Funds *Krugman
The Market for Loanable Funds Interest Rate Supply 5% Demand 0 $1,200 Loanable Funds (in billions of dollars) *Mankiw Copyright 2004 South-Western
Equilibrium in the Loanable Funds Market *Krugman
Savings, Investment Spending, and Government Policy *Krugman
Increasing Private Savings *Krugman
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.
Policy 1: Saving Incentives A tax decrease increases the incentive for households to save at any given interest rate. The supply of loanable funds curve shifts to the right. The equilibrium interest rate decreases. The quantity demanded for loanable funds increases.
An Increase in the Supply of Loanable Funds Interest Rate Supply, S 1 S 2 5% 4% 2.... which reduces the equilibrium interest rat e... 1. Tax incentives for saving increase the supply of loanable fund s... Demand 0 $1,200 $1,600 3.... and raises the equilibrium quantity of loanable funds. Loanable Funds (in billions of dollars) Copyright 2004 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.
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.
Policy 2: Investment Incentives If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving.
An Increase in the Demand for Loanable Funds Interest Rate 6% 5% Supply 1. An investment tax credit increases the demand for loanable fund s... 2.... which raises the equilibrium interest rate... Demand, D 1 D 2 0 $1,200 $1,400 3.... and raises the equilibrium quantity of loanable funds. Loanable Funds (in billions of dollars) Copyright 2004 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.
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.
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.
The Effect of a Government Budget Deficit Interest Rate S 2 Supply, S 1 2.... which raises the equilibrium interest rat e... 6% 5% 1. A budget deficit decreases the supply of loanable fund s... Demand 0 $800 $1,200 3.... and reduces the equilibrium quantity of loanable funds. Loanable Funds (in billions of dollars) Copyright 2004 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.
Policy 3: Government Budget Deficits and Surpluses A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment.
The U.S. Government Debt Percent of GDP 120 100 World War II 80 60 40 Revolutionary War Civil War World War I 20 0 1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010 Copyright 2004 South-Western
The Financial System - Definitions Wealth Financial asset Physical asset Liability Transaction costs Financial risk *Krugman
Risk-Averse Attitudes Toward Gain and Loss *Krugman
Three Tasks of a Financial System Reducing transaction costs Reducing financial risk Providing liquid assets *Krugman
Financial Intermediaries Mutual funds Pension funds Life insurance companies Banks Financial Fluctuations Financial market fluctuations can be a source of macroeconomic instability. Are markets irrational? Policy makers assume neither that markets always behave rationally nor that they can outsmart them. *Krugman
*Krugman
Summary The U.S. financial system is made up of financial institutions such as the bond market, the stock market, banks, and mutual funds. All these institutions act to direct the resources of households who want to save some of their income into the hands of households and firms who want to borrow.
Summary National income accounting identities reveal some important relationships among macroeconomic variables. In particular, in a closed economy, national saving must equal investment. Financial institutions attempt to match one person s saving with another person s investment.
Summary The interest rate is determined by the supply and demand for loanable funds. The supply of loanable funds comes from households who want to save some of their income. The demand for loanable funds comes from households and firms who want to borrow for investment.
Summary National saving equals private saving plus public saving. A government budget deficit represents negative public saving and, therefore, reduces national saving and the supply of loanable funds. When a government budget deficit crowds out investment, it reduces the growth of productivity and GDP.