Chapter 10: Economic Growth, the Financial System, and Business Cycles – Study Notes

Chapter 10: Economic Growth, the Financial System, and Business Cycles

10.1 Long-Run Economic Growth

Long-run economic growth refers to the sustained increase in a nation's output of goods and services over time, leading to a higher average standard of living. This is typically measured by real GDP per capita, which adjusts for changes in the price level and population size.

• Long-run vs. Short-run: Long-run growth is distinct from short-run fluctuations (business cycles), which are periods of economic expansion and recession.

• Real GDP per capita: The most common measure of average standard of living. It is calculated as the total real GDP divided by the population.

• Historical Growth: Real GDP per capita in the U.S. has increased more than nine-fold since 1900, indicating significant improvements in living standards.

Economic Prosperity and Health

• Richer nations can devote more resources to health, leading to higher life expectancy and productivity.

• Economic prosperity also allows for more leisure time as productivity and lifespan increase.

• Example: Life expectancy and discretionary hours have increased significantly in developed countries over the last century.

Calculating Growth Rates

• The growth rate of an economic variable (e.g., real GDP) is the percentage change from one year to the next.

$\text{Growth Rate} = \frac{\text{Value in Current Year} - \text{Value in Previous Year}}{\text{Value in Previous Year}} \times 100$

• Example: If real GDP was $21.4 trillion in 2021 and $21.8 trillion in 2022, the growth rate is:

$\frac{21.8 - 21.4}{21.4} \times 100 = 1.9\%$

• Average Growth Rate: Over several years, average the annual rates:

$\text{Average Annual Growth Rate} = \frac{\text{Sum of Annual Growth Rates}}{\text{Number of Years}}$

• Rule of 70: Estimates the number of years for a variable to double at a constant growth rate:

$\text{Number of years to double} = \frac{70}{\text{Growth rate (in percent)}}$

Determinants of Long-Run Growth

• Labor Productivity: The quantity of goods and services produced by one worker or one hour of work. Increases in labor productivity are the main driver of long-run growth.

Factors Affecting Labor Productivity Growth

1. Increases in Capital per Hour Worked: More physical capital (machines, tools) and human capital (skills, education) make workers more productive.

2. Technological Change: Innovations and improvements in production methods allow more output from the same inputs. Entrepreneurs play a key role in introducing new technologies.

3. Property Rights: Secure property rights and effective legal systems encourage investment and innovation.

Potential GDP

• Definition: The level of real GDP attained when all firms are operating at normal capacity (normal hours and workforce size).

• Potential GDP rises with increases in the labor force, capital stock, or technological progress.

• Actual GDP can fall below potential during recessions, creating an output gap.

10.2 Saving, Investment, and the Financial System

The financial system channels funds from savers to borrowers, facilitating investment and long-run economic growth.

Financial Markets and Financial Intermediaries

• Financial Markets: Where financial securities (stocks, bonds) are bought and sold.

• Financial Security: A document stating the terms under which funds pass from buyer to seller.

• Stock: Represents partial ownership in a firm.

• Bond: A loan from a household to a firm, promising repayment with interest.

• Financial Intermediaries: Institutions (banks, mutual funds, pension funds, insurance companies) that borrow from savers and lend to borrowers.

Services Provided by the Financial System

• Risk Sharing: Diversification allows investors to reduce risk while maintaining expected returns.

• Liquidity: Savers can quickly convert investments into cash.

• Information: Security prices reflect collective beliefs about future returns, guiding funds to the most promising investments.

The Macroeconomics of Savings and Investment

• In a closed economy (no exports or imports), GDP ($Y$) is the sum of consumption ($C$), investment ($I$), and government purchases ($G$):

$Y = C + I + G$

• Rearranged for investment:

$I = Y - C - G$

• Savings: Composed of private savings (households) and public savings (government).

$S_{private} = Y + TR - C - T$ $S_{public} = T - G - TR$ $S = S_{private} + S_{public} = Y - C - G$

• Thus, in equilibrium, savings equals investment ($S = I$).

• Budget Deficit: When government spending exceeds revenue ($S_{public} < 0$).

• Budget Surplus: When government revenue exceeds spending ($S_{public} > 0$).

The Market for Loanable Funds

• A conceptual market where savers supply funds and borrowers demand funds, determining the equilibrium interest rate and quantity of loanable funds.

• Households supply funds; firms demand funds for investment.

• Government borrowing (to fund deficits) reduces the supply of funds available for private investment (crowding out).

Summary Table: Loanable Funds Model

An increase in ...	Will shift the ...	Causing ...
Government's budget deficit	Supply of loanable funds curve to the left	Real interest rate to increase, investment to decrease
Desire of households to consume today	Supply of loanable funds curve to the left	Real interest rate to increase, investment to decrease
Tax benefits for saving (e.g., 401(k) retirement accounts)	Supply of loanable funds curve to the right	Real interest rate to decrease, investment to increase
Technological change making investment more profitable	Demand for loanable funds curve to the right	Real interest rate and investment to increase

Crowding Out

• Crowding out: A decline in private investment due to increased government borrowing.

• In practice, the effect on interest rates is relatively small due to the influence of global financial markets.

10.3 The Business Cycle

The business cycle refers to the alternating periods of economic expansion and recession experienced by an economy over time.

• Expansion: Period when real GDP is rising.

• Recession: Period when real GDP is falling.

• Peak: The point at which the economy shifts from expansion to recession.

• Trough: The point at which the economy shifts from recession to expansion.

Business Cycle Features

• Near the end of an expansion, interest rates and wages rise, but firm profits may fall.

• During a recession, firms cut investment and employment, leading to further declines in spending.

• Recovery begins as firms and households anticipate future expansion and increase spending.

Effects on Inflation and Unemployment

• Inflation: Tends to rise during expansions and fall (or even become negative) during recessions.

• Unemployment: Rises during recessions as firms reduce production and lay off workers; may continue to rise even after a recession ends.

Predicting Recessions

• Business cycles are not uniform, and leading indicators are unreliable.

• Events triggering recessions are often unpredictable.

The Great Moderation

• Since the mid-1980s, U.S. business cycles have become milder, with longer expansions and shorter, less severe recessions (except for the Great Recession of 2007–2009 and the Covid-19 recession).

• Factors contributing to stability include the shift to a service-based economy, establishment of unemployment insurance, active government stabilization policies, and increased financial system stability.