0. Education
Govt can increase productivity by promoting education–investment in human capital (H).
public schools, subsidized loans for college
Education has significant effects: In the U.S., each year of schooling raises a worker’s wage by 10%.
But investing in H also involves a tradeoff between the present & future: Spending a year in school requires sacrificing a year’s wages now to have higher wages later.
The 4th edition of the textbook has an excellent new In the News box, entitled “Promoting Human Capital.” It contains a 2004 New York Times article on a policy Brazil has implemented which gives families cash payments if their children attend school faithfully. Other developing countries have similar policies, which experts predict will raise productivity and living standards in the long run.
CHAPTER PRODUCTION AND GROWTH

1. Health and Nutrition
Health care expenditure is a type of investment in human capital – healthier workers are more productive.
In countries with significant malnourishment, raising workers’ caloric intake raises productivity:
Over , caloric consumption rose 44% in S. Korea, and economic growth was spectacular.
This section is brand-new to the 4th edition.
You might want to point out that the positive correlations between living standards and education or health & nutrition could result from causality in either direction:
Investing in human capital – either through education or improving health & nutrition – can indeed lead to higher incomes in the long run. But it is equally true that countries with higher incomes can afford to devote more resources to schooling or improving health & nutrition.
CHAPTER PRODUCTION AND GROWTH

2. caloric consumption
CHAPTER PRODUCTION AND GROWTH

3. Nobel winner Robert Fogel
30% of Great Britain’s growth from was due to improved nutrition.
CHAPTER PRODUCTION AND GROWTH

4. Property Rights and Political Stability
Recall: Markets are usually a good way to organize economic activity. The price system allocates resources to their most efficient uses.
This requires respect for property rights, the ability of people to exercise authority over the resources they own.
CHAPTER PRODUCTION AND GROWTH

5. Property Rights and Political Stability
In many poor countries, the justice system doesn’t work very well:
contracts aren’t always enforced
fraud, corruption often go unpunished
in some, firms must bribe govt officials for permits
Political instability (e.g., frequent coups) creates uncertainty over whether property rights will be protected in the future.
CHAPTER PRODUCTION AND GROWTH

6. Property Rights and Political Stability
When people fear their capital may be stolen by criminals or confiscated by a corrupt govt, there is less investment, including from abroad, and the economy functions less efficiently. Result: lower living standards.
Economic stability, efficiency, and healthy growth require law enforcement, effective courts, a stable constitution, and honest govt officials.
CHAPTER PRODUCTION AND GROWTH

7. Free Trade
Inward-oriented policies (e.g., tariffs, limits on investment from abroad) aim to raise living standards by avoiding interaction with other countries.
Outward-oriented policies (e.g., the elimination of restrictions on trade or foreign investment) promote integration with the world economy.
The World Trade Organization is the only global international organization dealing with the rules of trade between nations. At its heart are the WTO agreements, negotiated and signed by the bulk of the world’s trading nations and ratified in their parliaments.
CHAPTER PRODUCTION AND GROWTH

8. CHAPTER 25 PRODUCTION AND GROWTH

9. Free Trade Recall: Trade can make everyone better off.
Trade has similar effects as discovering new technologies – it improves productivity and living standards.
Countries with inward-oriented policies have generally failed to create growth.
e.g., Argentina during the 20th century.
Countries with outward-oriented policies have often succeeded.
e.g., South Korea, Singapore, Taiwan after 1960.
The 4th edition contains a new “In the News” box called “Rich Farmers vs. the World’s Poor.” It contains an op-ed piece by the presidents of two poor countries entitled “Your Farm Subsidies Are Strangling Us.” It is an excellent article – please encourage your students to read it carefully. (One way to do this is announce that the next exam will contain questions on this article.)
Incidentally, this article is also excellent for use when teaching the chapter entitled “Application: International Trade,” which uses the tools of welfare economics to assess trade and trade policy. This chapter appears as Chapter 9 of every version of this textbook except Brief Principles of Macroeconomics.
CHAPTER PRODUCTION AND GROWTH

10. Now, the key
“ I am looking for a lot of men who have infinite capacity to not know what can't be done.”
-- Henry Ford
CHAPTER PRODUCTION AND GROWTH

11. Research and Development
Technological progress is the main reason why living standards rise over the long run.
One reason is that knowledge is a public good: Ideas can be shared freely, increasing the productivity of many.
Policies to promote tech. progress:
patent laws
tax incentives or direct support for private sector R&D
grants for basic research at universities
CHAPTER PRODUCTION AND GROWTH

12. Population Growth …may affect living standards in 3 different ways:
1. Stretching natural resources
200 years ago, Malthus argued that pop. growth would strain society’s ability to provide for itself.
Since then, the world population has increased sixfold. If Malthus was right, living standards would have fallen. Instead, they’ve risen.
Malthus failed to account for technological progress and productivity growth.
CHAPTER PRODUCTION AND GROWTH

13. Population Growth 2. Diluting the capital stock
more population = higher L = lower K/L = lower productivity & living standards.
This applies to H as well as K: fast pop. growth = more children = greater strain on educational system.
Countries with fast pop. growth tend to have lower educational attainment.
CHAPTER PRODUCTION AND GROWTH

14. Population Growth 2. Diluting the capital stock
To combat this, many developing countries use policy to control population growth.
China’s one child per family laws
contraception education & availability
promote female literacy to raise opportunity cost of having babies
CHAPTER PRODUCTION AND GROWTH

15. Population Growth 3. Promoting tech. progress More people
= more scientists, inventors, engineers
= more frequent discoveries
= faster tech. progress & economic growth
Over the course of human history,
growth rates increased as the world’s population increased
more populated regions grew faster than less populated ones
The textbook cites research by Michael Kremer published in the 1993 Quarterly Journal of Economics.
CHAPTER PRODUCTION AND GROWTH

16. A C T I V E L E A R N I N G 2: Productivity
List the determinants of productivity.
List three policies that attempt to raise living standards by increasing one of the determinants of productivity.
This activity serves as a quick check of students’ comprehension of the material in this chapter.
It’s also interesting to see whether their policy suggestions here reveal any improvement in learning over the discussion of policies in Active Learning 1, above. 16

17. A C T I V E L E A R N I N G 2: Answers
Determinants of productivity: physical capital per worker (K/L) human capital per worker (H/L) natural resources per worker (N/L) technological knowledge (A)
Policies to boost productivity:
Encourage saving and investment, to raise K/L
Encourage investment from abroad, to raise K/L
Provide public education, to raise H/L 17

18. A C T I V E L E A R N I N G 2: Answers
Determinants of productivity: physical capital per worker (K/L) human capital per worker (H/L) natural resources per worker (N/L) technological knowledge (A)
Policies to boost productivity:
Patent laws or grants, to increase A
Control population growth, to increase K/L
Students may name other policies, such as:
(1) promote free trade or pursue outward-oriented trade policies
(2) crack down on corruption or otherwise protect and enforce property rights
Based on the discussion in this chapter, it may not be obvious which of the determinants of productivity these policies affect. I think a case could be made that (1) and (2) affect “A” (boosting economic efficiency) and that (2) also affects K/L. 18

19. Are Natural Resources a Limit to Growth?
Some argue that population growth is depleting the Earth’s non-renewable resources, and thus will limit growth in living standards.
But technological progress often yields ways to avoid these limits:
Hybrid cars use less gas.
Better insulation in homes reduces the energy required to heat or cool them.
As a resource becomes scarcer, its market price rises, which increases the incentive to conserve it and develop alternatives.
I moved this case study from the middle of the chapter to the end of this PowerPoint presentation. Feel free to move it back if you wish.
Due to space constraints, the last bullet point is a bit different than the corresponding material in the textbook. The textbook argues the following:
In a market economy, scarcity is reflected in market prices. If the world were running out of natural resources, the prices of those resources would be rising over time. But, in fact, they are not. The prices of most natural resources (in real terms) are stable or falling. It appears that our ability to conserve these resources is growing more rapidly than their supplies are dwindling.
CHAPTER PRODUCTION AND GROWTH

20. CONCLUSION
In the long run, living standards are determined by productivity.
Policies that affect the determinants of productivity will therefore affect the next generation’s living standards.
One of these determinants is saving and investment.
In the next chapter, we will learn how saving and investment are determined, and how policies can affect them.
This slide alludes to the chapter entitled “Saving, Investment, and the Financial System,” which immediately follows the current chapter. If you will not be covering that chapter, then you should delete or edit this slide.
CHAPTER PRODUCTION AND GROWTH

21. This coming Tuesday, 1st Midterm
No. 2 pencils
Scantron form: Parscore form F-288-ERI-L
Ink pens
Non-programmable calculator
Picture ID.
1 hour and 10 minutes.
Regular lecture time and lecture room.
CHAPTER PRODUCTION AND GROWTH

22. We have…
Realized that capital accumulation is one of the driving forces for growth.
Now…
We explore the ECONOMICS of capital accumulation.
Why would firms purchase capital?
Where does the capital come?
CHAPTER PRODUCTION AND GROWTH

23. 26 Saving, Investment, and the Financial System
P R I N C I P L E S O F
F O U R T H E D I T I O N
This chapter is an excellent follow-up to the previous one (“Production and Growth”). In that chapter, we learn that investment – the accumulation of capital – is important because it leads to a higher standard of living in the long run. But what determines how much investment a country undertakes? That is the central question of the present chapter.
After some introductory information about the various types of financial institutions, the chapter focuses on saving and investment. Students will learn the difference between private and public saving, and the definitions of government budget surpluses and deficits. The brief review of the difference between saving and investment is very useful, as intro-level students often use the term “investment” when they mean to say “saving.”
The most analytical part of the chapter is the coverage of the closed-economy loanable funds model. This model uses the tools of supply and demand (introduced in chapter 4), and should be very familiar if your students have already taken introductory microeconomics.
The loanable funds model shows how the interest rate adjusts to equate saving and investment in a closed economy. Students will learn how government budget deficits can crowd out investment, which is probably one of the biggest ideas in macroeconomics.

24. In this chapter, look for the answers to these questions:
What are the main types of financial institutions in the U.S. economy, and what is their function?
What are the three kinds of saving?
What’s the difference between saving and investment?
How does the financial system coordinate saving and investment?
How do govt policies affect saving, investment, and the interest rate?
CHAPTER PRODUCTION AND GROWTH

25. Robinson-Crusoe Economy Again…
CHAPTER PRODUCTION AND GROWTH

26. Saving of Robinson Robinson lives alone; He makes a living by fishing;
Notice that Robinson is the producer AND the consumer; or, in another word, he is the firm AND the household.
Suppose fish is storable. Robinson can either eat all the fish he catches, or eat part of it and store the rest – Robinson Saves!
Why would he save? Notice that Robinson has to eat some fish everyday to keep himself alive.
He knows he may get sick one day; (save for unemployment)
He may need a break the next day; (save for vacation)
He plans to make fishnets the next day to catch more fishes in the future – Robinson invests! (save for investment).
Note that saving for investment happens only when consumers are the producers.
CHAPTER PRODUCTION AND GROWTH

27. Now, make it more real… Fish can be storable, but not for ever.
In the real world, capital depreciates.
If we make the extreme assumption that fish is non-storable, can Robinson save?
CHAPTER PRODUCTION AND GROWTH

28. Yes, he can; but not alone
Suppose there are two Robinsons.
Robinson Robinson 2
CHAPTER PRODUCTION AND GROWTH

29. Two Robinsons can make arrangement
Robinson 1 gets sick one day and cannot catch fish.
Robinson 2 helps him out by sharing fish with him
But Robinson 1 makes the promise that he will return the fish back once he recovers and fishes again.
In this case, Robinson 1 is the borrower and Robinson 2 is the saver.
The income of the saver goes to the borrower.
CHAPTER PRODUCTION AND GROWTH

30. Two Robinsons can make another arrangement…
Robinson 1 wants to spend a day making fishnets to catch more fish in the future;
Robinson 2 helps Robinson 1 by sharing fish with him; Robinson 1 promises that he will give the fish back.
In this case, Robinson 2 is still the saver, but Robinson 1 is the investor.
The investment is financed by saving!
CHAPTER PRODUCTION AND GROWTH

31. When there are only two Robinsons
They talk and make arrangement;
When there are millions of people as in the real world…
Things take place through MARKET;
In this case, firms’ investment are financed by households’ saving through FINANCIAL MARKETS or FINANCIAL INTERMEDIARIES – together they constitute financial system
CHAPTER PRODUCTION AND GROWTH

32. Financial Institutions
The financial system: the group of institutions that helps match the saving of one person with the investment of another.
Direct interaction – Financial Markets (bonds market, stock market)
Indirect interaction – Financial Intermediaries. (banks, mutual funds)
CHAPTER PRODUCTION AND GROWTH

33. Direct interaction between savors and borrowers
Financial markets: institutions through which savers can directly provide funds to borrowers. Examples:
The Bond Market. A bond is a certificate of indebtedness.
The Stock Market. A stock is a claim to partial ownership in a firm.
CHAPTER PRODUCTION AND GROWTH

34. A BOND Date of maturity: the time when the loan will be paid;
Rate of interest that will be paid periodically until the loan matures.
Bonds are risky!
CHAPTER PRODUCTION AND GROWTH

35. Historical Railroad Bond
CHAPTER PRODUCTION AND GROWTH

36. The Stock Market Partial ownership by funding the purchase of capital;
Declares share of the corporate profits;
Stocks are riskier than bonds, why?
Bond represents a firm’s obligation to pay the money back.
Investors take the risks themselves by purchasing the partial ownership.
Before a firm goes bankrupt, its remaining assets are used first to pay off the debts.
CHAPTER PRODUCTION AND GROWTH

37. Stock Exchange
Once stocks are issued, they change owners via the stock exchange market.
NY Stock Exchange
American Stock Exchange
NASDAQ
Stock price of a firm depends on
The firms’ profitability
People’s perception for the firms’ future.
CHAPTER PRODUCTION AND GROWTH

38. 1929 Crash of the NY Stock Exchange during the Great Depression
Capital is the tools needed to produce things of value out of raw materials. Buildings and machines are common examples of capital. A factory is a building with machines for making valued goods. Throughout the twentieth century, most of the capital in the United States was represented by stocks. A corporation owned capital. Ownership of the corporation in turn took the form of shares of stock. Each share of stock represented a proportionate share of the corporation. The stocks were bought and sold on stock exchanges, of which the most important was the New York Stock Exchange located on Wall Street in Manhattan. 
Throughout the 1920s a long boom took stock prices to peaks never before seen. From 1920 to 1929 stocks more than quadrupled in value. Many investors became convinced that stocks were a sure thing and borrowed heavily to invest more money in the market. 
But in 1929, the bubble burst and stocks started down an even more precipitous cliff. In 1932 and 1933, they hit bottom, down about 80% from their highs in the late 1920s. This had sharp effects on the economy. Demand for goods declined because people felt poor because of their losses in the stock market. New investment could not be financed through the sale of stock, because no one would buy the new stock. 
CHAPTER PRODUCTION AND GROWTH

39. NASDAQ: the world’s biggest electronic stock exchange system
CHAPTER PRODUCTION AND GROWTH

40. Stock Price Indexes
Just like GDP deflator is the average price for all goods and services produced in the US;
Stock price indexes is the average price of different companies’ stock prices.
Depending on which companies’ stock price is included, we have:
Dow Jones Industrial Average: 30 major US companies such as GM, AT&T…
Standard&Poor’s 500 Index: 500 major companies.
CHAPTER PRODUCTION AND GROWTH

41. Financial Institutions
Financial intermediaries: institutions through which savers can indirectly provide funds to borrowers. Examples:
Banks that take deposits from the households and make loans to firms.
Mutual funds – institutions pool savings from the public that is invested and managed on their behalf by professional money managers.
CHAPTER PRODUCTION AND GROWTH

42. Mutual Funds
CHAPTER PRODUCTION AND GROWTH

43. Different Kinds of Saving
Private saving
= The portion of households’ income that is not used for consumption or paying taxes
= Y – T – C
Public saving
= Tax revenue less government spending
= T – G
In case anyone asks, “T” here (and in general) is net of transfer payments.
After presenting this slide and the next, it might be useful to point out the following:
In general, “saving” is just some measure of income minus some measure of expenditure.
For private (household) saving, the measure of income is “disposable income,” or gross income minus taxes (“take-home pay.”) The measure of expenditure is consumption.
For public (government) saving, the measure of income is T, total taxes, which is the government’s source of “income.” The measure of expenditure is simply G, government purchases.
In the case of national saving (covered on the next slide), the measure of income is GDP, and the measure of expenditure is C+G.
CHAPTER PRODUCTION AND GROWTH

44. National Saving National saving = private saving + public saving
= (Y – T – C) (T – G)
= Y – C – G
= the portion of national income that is not used for consumption or government purchases
CHAPTER PRODUCTION AND GROWTH

45. Saving = investment in a closed economy
Saving and Investment
Recall the national income accounting identity:
Y = C + I + G + NX (-5.8%)
For the rest of this chapter, focus on the closed economy case:
Y = C + I + G
Solve for I:
national saving
In defense of the closed economy assumption:
It’s true that most economies are open. However, the closed economy case is easier to learn, and we can still learn a lot about how the world works by studying the closed economy case.
A later chapter will add international trade and capital flows to this model.
I = Y – C – G
= (Y – T – C) + (T – G)
Saving = investment in a closed economy
CHAPTER PRODUCTION AND GROWTH

46. Budget Deficits and Surpluses
Budget surplus
= an excess of tax revenue over govt spending
= T – G
= public saving
Budget deficit
= a shortfall of tax revenue from govt spending
= G – T
= – (public saving)
CHAPTER PRODUCTION AND GROWTH

47. A C T I V E L E A R N I N G 1: Exercise
Suppose GDP equals $10 trillion, consumption equals $6.5 trillion, the government spends $2 trillion and has a budget deficit of $300 billion.
Find public saving, taxes, private saving, national saving, and investment.
This exercise asks your students to apply the concepts from the preceding slides to the kind of problem they might see on an upcoming exam.
CHAPTER PRODUCTION AND GROWTH 47

48. A C T I V E L E A R N I N G 1: Answers
Given: Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3
Public saving = T – G = – 0.3
Taxes: T = G – 0.3 = 1.7
Private saving = Y – T – C = 10 – 1.7 – 6.5 = 1.8
National saving = Y – C – G = 10 – 6.5 = 2 = 1.5
Investment = national saving = 1.5
All numbers are in trillions of dollars.
CHAPTER PRODUCTION AND GROWTH 48

49. A C T I V E L E A R N I N G 1B: Exercise
Now suppose the government cuts taxes by $200 billion.
In each of the following two scenarios, determine what happens to public saving, private saving, national saving, and investment.
1. Consumers save the full proceeds of the tax cut.
2. Consumers save 1/4 of the tax cut and spend the other 3/4.
This exercise is designed to teach an important lesson and prevent a common mistake among students.
When students are asked (on an exam, for example) to determine the effects of a tax cut on national saving, investment, and the interest rate, many students mistakenly state that the tax change has no effects, because taxes enter positively in the expression for public saving, negatively in the expression for private saving, and not at all in the expression for national saving (Y – C – G).
This exercise gets students to see that the effects of a tax cut on national saving and investment depend on the behavior of consumers.
Immediately following this exercise is a discussion question designed to help students realize that the tax cut will most likely cause consumption to rise and national saving to fall.
Of course, if you intend to teach your students that Ricardian Equivalence is an accurate description of the world, then you’d want to argue that scenario 1 is the most realistic. The reason for this, according to Ricardian Equivalence, is that consumers are forward-looking and realize that a tax cut today must be matched by a future tax increase that is equal in present value to today’s tax cut. Please be aware, however, that Ricardian Equivalence is not covered in this chapter, so it is not supported with test-bank or study guide questions.
CHAPTER PRODUCTION AND GROWTH 49

50. A C T I V E L E A R N I N G 1B: Answers
In both scenarios, public saving falls by $200 billion, and the budget deficit rises from $300 billion to $500 billion.
1. If consumers save the full $200 billion, national saving is unchanged, so investment is unchanged.
2. If consumers save $50 billion and spend $150 billion, then national saving and investment each fall by $150 billion.
CHAPTER PRODUCTION AND GROWTH 50

51. A C T I V E L E A R N I N G 1C: Discussion questions
The two scenarios are:
1. Consumers save the full proceeds of the tax cut.
2. Consumers save 1/4 of the tax cut and spend the other 3/4.
Which of these two scenarios do you think is the most realistic?
Why is this question important?
If students have trouble understanding the first question, you can rephrase it in terms they are likely to grasp:
Suppose a tax cut causes your annual take-home pay to rise from $40,000 to $42,000. What would you do with that extra $2000? Would you save ALL of it? Or would you spend at least part of it?
In this light, most students would agree that the most realistic scenario involves consumers spending at least part of the proceeds of the tax cut.
The answer to the first question determines whether a tax cut reduces investment. This is important because a fall in investment would cause, in the long run, a fall in the standard of living, according to what we learned in the Production and Growth chapter.
The bigger point is this: while tax cuts seem appealing (nobody likes paying taxes, after all), they are not without cost. Later in the chapter, we will see HOW a tax cut causes investment to fall in a closed economy. (Answer: by raising interest rates.)
CHAPTER PRODUCTION AND GROWTH 51

52. The Meaning of Saving and Investment
Private saving is the income remaining after households pay their taxes and pay for consumption.
Examples of what households do with saving:
buy corporate bonds or equities
purchase a certificate of deposit at the bank
buy shares of a mutual fund
let accumulate in saving or checking accounts
CHAPTER PRODUCTION AND GROWTH

53. The Meaning of Saving and Investment
Investment is the purchase of new capital.
Examples of investment:
General Motors spends $250 million to build a new factory in Flint, Michigan.
You buy $5000 worth of computer equipment for your business.
Your parents spend $300,000 to have a new house built.
In principle, students should already know the meaning of “investment,” which was introduced in the “Measuring National Income” chapter. However, many students continue to think of “investment” as the purchase of stocks, bonds, or other assets. At this point in the chapter, a review of “saving” and “investment” is especially worthwhile, because the next topic is the loanable funds model. In this model, saving is the supply of funds and investment is the demand.
There’s a connection between the economics definition of investment and the commonplace usage of the term: What laypeople think of as financial investment (the purchase of stocks and bonds, etc) is what finances investment in physical capital. For example, General Motors may sell $300 million worth of bonds to raise the funds it needs to pay for its new factory in Flint, Michigan. In this case, people buying the bonds are doing “investment” in the layperson’s sense of the term, and G.M. is using their funds to pay for the physical investment.
Remember: In economics, investment is NOT the purchase of stocks and bonds!
CHAPTER PRODUCTION AND GROWTH

54. Saving finances investment via Financial System
Financial Markests
Bonds market
Stock market
Financial Intermediaries
Banks;
Mutual funds.
CHAPTER PRODUCTION AND GROWTH

55. The Market for Loanable Funds
A supply-demand model of the financial system.
Helps us understand
how the financial system coordinates saving & investment
how govt policies and other factors affect saving, investment, the interest rate
CHAPTER PRODUCTION AND GROWTH

56. The Market for Loanable Funds
Assume: only one financial market.
All savers deposit their saving in this market.
All borrowers take out loans from this market.
There is one interest rate, which is both the return to saving and the cost of borrowing.
In defense of the assumption of just one financial market:
We are using this model to study the aggregate financial system. It’s fine to assume there’s only one type of asset as long as we don’t need to know how households divide their financial wealth into various types of assets.
An analogy might help. Suppose you want to know how a fall in consumer income affects the automobile market. You could draw a supply-demand model for autos, in which the demand curve would shift leftward, causing the price and quantity to fall. Of course, this model ignores the fact that there are lots of different types of vehicles, but that isn’t relevant to the issue at hand.
CHAPTER PRODUCTION AND GROWTH

57. The Market for Loanable Funds
The supply of loanable funds comes from saving:
Households with extra income can loan it out and earn interest.
Public saving, if positive, adds to national saving and the supply of loanable funds.
If negative, it reduces national saving and the supply of loanable funds.
CHAPTER PRODUCTION AND GROWTH

58. The Slope of the Supply Curve
An increase in the interest rate makes saving more attractive, which increases the quantity of loanable funds supplied.
Interest Rate
Loanable Funds ($billions)
Supply 80 6% 60 3%
CHAPTER PRODUCTION AND GROWTH

59. The Market for Loanable Funds
The demand for loanable funds comes from investment:
Firms borrow the funds they need to pay for new equipment, factories, etc.
Households borrow the funds they need to purchase new houses.
CHAPTER PRODUCTION AND GROWTH

60. The Slope of the Demand Curve
A fall in the interest rate reduces the cost of borrowing, which increases the quantity of loanable funds demanded.
Interest Rate
Loanable Funds ($billions)
Demand 50 7% 4% 80
CHAPTER PRODUCTION AND GROWTH

61. Equilibrium The interest rate adjusts to equate supply and demand.
Loanable Funds ($billions)
Supply
Demand
The eq’m quantity of L.F. equals eq’m investment and eq’m saving. 5% 60
Due to space constraints, this slide uses “L.F.” to stand for loanable funds, and “eq’m” to stand for equilibrium.
If the interest rate were lower than the equilibrium level, demand for funds would exceed supply, causing the interest rate to rise. The rise in the rate would make borrowing more costly, and thus would reduce the demand for funds. The rise in the interest rate would also encourage households to save more, which would increase the supply of funds. This process would occur until equilibrium was achieved.
If the interest rate were higher than equilibrium, there would be a surplus of funds. The interest rate would fall to restore equilibrium.
In the real world, the adjustment to equilibrium in financial markets is extremely rapid.
CHAPTER PRODUCTION AND GROWTH

62. Policy 1: Saving Incentives
Tax incentives for saving increase the supply of L.F.
Interest Rate S1 S2
…which reduces the eq’m interest rate 5% 4%
and increases the eq’m quantity of L.F. 70
There’s an implicit assumption in this analysis that overall tax revenues remain unchanged in spite of the tax incentives. Taken literally, we would have to assume that other taxes are raised to exactly offset the loss in revenue from the saving incentives. Without this implicit assumption, total tax revenues would fall, causing saving to fall, and shifting the supply curve leftward, which would mitigate the effects shown here.
You may or may not wish to point this out to your students. If you are especially nitpicky, or your students are particularly sharp, then it’s probably worth telling them. (Note, however, that the assumption of constant total revenue remains implicit in the textbook’s discussion of this policy.) D1 60
Loanable Funds ($billions)
CHAPTER PRODUCTION AND GROWTH

63. Policy 2: Investment Incentives
An investment tax credit increases the demand for L.F.
Interest Rate D2 S1 6% 70
…which raises the eq’m interest rate 5%
and increases the eq’m quantity of L.F.
As with Policy 1, you may wish to note that we are assuming the tax credit does not significantly reduce the overall amount of taxes. If total taxes fell, then the supply curve would shift (in addition to the demand curve). However, our intention here is to focus solely on the demand shift. D1 60
Loanable Funds ($billions)
CHAPTER PRODUCTION AND GROWTH

64. Policy 3: Govt Budget Deficits
A budget deficit reduces national saving and the supply of L.F. S2
Interest Rate S1 6% 50
…which increases the eq’m interest rate 5%
and decreases the eq’m quantity of L.F.
This slide is “hidden” and will not appear in the slide show presentation. I provided it in case you wish to lecture on the effects of budget deficits instead of having students do the analysis themselves in the exercise from Active Learning 2. If so, move this slide to that location and “unhide” this slide, by unselecting “hide” in the Slide Show menu.
The analysis shows that the budget deficit reduces investment, which the preceding chapter shows is important for the long-run standard of living. This is one reason why many economists believe budget deficits are generally undesirable.
In the real world, we sometimes see increases in government budget deficits that are not accompanied by dollar-for-dollar decreases in investment, as the analysis on this slide would predict. Keep in mind, however, that the analysis here is for the closed economy model. In an open economy, firms can finance investment by borrowing from abroad in the face of a decrease in the domestic supply of loanable funds.
This, of course, does not mean that budget deficits are “okay” in an open economy, because the extra indebtedness requires service, such as interest or dividend payments, which reduces the amount of income remaining for residents of the country. D1 60
Loanable Funds ($billions)
CHAPTER PRODUCTION AND GROWTH

65. A C T I V E L E A R N I N G 2: Exercise
Use the loanable funds model to analyze the effects of a government budget deficit:
Draw the diagram showing the initial equilibrium.
Determine which curve shifts when the government runs a budget deficit.
Draw the new curve on your diagram.
What happens to the equilibrium values of the interest rate and investment?
Now that you have shown students the analysis of Policies 1 and 2, this exercise asks them to do the analysis of Policy 3 (a budget deficit).
In case you prefer to lecture on this material, I have provided a “hidden” slide at the end of this file that contains the budget deficit analysis as a lecture slide instead of an exercise. Move that slide to this location and “unhide” it by unselecting the “hide slide” command on the Slide Show menu.
CHAPTER PRODUCTION AND GROWTH 65

66. A C T I V E L E A R N I N G 2: Answers
A budget deficit reduces national saving and the supply of L.F. S2
Interest Rate S1
…which increases the eq’m interest rate 6% 50 5%
and decreases the eq’m quantity of L.F. and investment.
The analysis shows that the budget deficit reduces investment, which the preceding chapter shows is important for the long-run standard of living. This is one reason why many economists believe budget deficits are generally undesirable.
In the real world, we sometimes see increases in government budget deficits that are not accompanied by dollar-for-dollar decreases in investment, as the analysis on this slide would predict. Keep in mind, however, that the analysis here is for the closed economy model. In an open economy, firms can finance investment by borrowing from abroad in the face of a decrease in the domestic supply of loanable funds.
This, of course, does not mean that budget deficits are “okay” in an open economy, because the extra indebtedness requires service, such as interest or dividend payments, which reduces the amount of income remaining for residents of the country. D1 60
Loanable Funds ($billions)
CHAPTER PRODUCTION AND GROWTH 66

67. Budget Deficits, Crowding Out, and Long-Run Growth
Our analysis: increase in budget deficit causes fall in investment.
The govt borrows to finance its deficit, leaving less funds available for investment.
This is called crowding out.
Recall from the preceding chapter: Investment is important for long-run economic growth. Hence, budget deficits reduce the economy’s growth rate and future standard of living.
If the last statement on this slide troubles you, here is my defense:
While the budget deficit does not affect the steady state growth rate of neoclassical growth theory, it affects the economy’s growth rate temporarily (long enough to reduce the steady-state level of income per capita). And in some endogenous growth models, budget deficits can affect the steady state growth rate.
If you are still troubled, you can modify the statement so that it is more consistent with neoclassical growth theory.
CHAPTER PRODUCTION AND GROWTH

68. The U.S. Government Debt
The government finances deficits by borrowing (selling government bonds).
Persistent deficits lead to a rising govt debt.
The ratio of govt debt to GDP is a useful measure of the government’s indebtedness relative to its ability to raise tax revenue.
Historically, the debt-GDP ratio usually rises during wartime and falls during peacetime – until the early 1980s.
CHAPTER PRODUCTION AND GROWTH

69. U.S. Government Debt as a Percentage of GDP, 1970-2005
WW2
Revolutionary War
Civil War
WW1
From the beginning of this long time series until about 1980, the data show a clear pattern: the debt-GDP ratio jumps up during wartime, and comes back down during peacetime. (Also, the Great Depression caused revenues to plummet, and led to a rise in the debt ratio during the 1930s.)
There are two reasons why many economists believe it is appropriate to allow the debt ratio to climb during wars. First, it allows the government to keep tax rates smooth over time. Wars are expensive, and financing them solely with tax increases would be disruptive to the economy and would cause a substantial reduction in economic efficiency. Second, debt finance shifts part of the cost of the war to future generations. This is appropriate, one could argue, because future generations benefit when the government goes to war to defend the nation against foreign aggressors.
The pattern visible throughout most of history breaks down around 1980, when the debt ratio started climbing despite the lack of a major war. This was due to the Reagan tax cuts, and growth in federal entitlement outlays during the 1980s.
From 1992 to 2000, the longest expansion on record plus a strong stock market in led to a surge in revenues, the first budget surpluses in many years, and a declining debt-GDP ratio.
From , the ratio to start climbing again due to the Bush tax cuts, the 2001 recession, and the wars (Afghanistan, Iraq, and the War on Terror).
CHAPTER PRODUCTION AND GROWTH

70. CONCLUSION
Like many other markets, financial markets are governed by the forces of supply and demand.
One of the Ten Principles from Chapter 1: Markets are usually a good way to organize economic activity.
Financial markets help allocate the economy’s scarce resources to their most efficient uses.
Financial markets also link the present to the future: They enable savers to convert current income into future purchasing power, and borrowers to acquire capital to produce goods and services in the future.
It might be worth elaborating for a moment on “financial markets help allocate the economy’s scarce resources to their most efficient uses.”
The scarce resources this statement refers to are the loanable funds. They are scarce because there are more investment projects needing funding than funds available. So how should the scarce funds be allocated? I.e., which investment projects should get the available funds? The investment projects with the highest expected returns, of course. And the projects with the highest expected returns would have the highest willingness to pay for funds.
Hence, supply and demand for funds determines the equilibrium interest rate, and all projects with returns at or above that interest rate will be funded; the projects with expected returns below the interest rate will not be funded. In this way, the economy gets the most “bang” (future productive capacity) out of its investment “buck.” Just another reason why capitalism is such a beautiful thing!
CHAPTER PRODUCTION AND GROWTH

71. CHAPTER SUMMARY
The U.S. financial system is made up of many types of financial institutions, like the stock and bond markets, banks, and mutual funds.
National saving equals private saving plus public saving.
In a closed economy, national saving equals investment. The financial system makes this happen.
CHAPTER PRODUCTION AND GROWTH

72. CHAPTER SUMMARY
The supply of loanable funds comes from saving. The demand for funds comes from investment. The interest rate adjusts to balance supply and demand in the loanable funds market.
A government budget deficit is negative public saving, so it reduces national saving, the supply of funds available to finance investment.
When a budget deficit crowds out investment, it reduces the growth of productivity and GDP.
CHAPTER PRODUCTION AND GROWTH