1 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles

2 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles

3 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles CHAPTER 9 Economic Growth, the Financial System, and Business Cycles Boeing has experienced growth over the long run, while being affected by the business cycle. Fernando Quijano Prepared by:

4 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles 9.1Long-Run Economic Growth Discuss the importance of long- run economic growth. 9.2Saving, Investment, and the Financial System Discuss the role of the financial system in facilitating long-run economic growth. 9.3The Business Cycle Explain what happens during the business cycle. CHAPTER 9 Chapter Outline and Learning Objectives Economic Growth, the Financial System, and Business Cycles

5 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :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.

6 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Long-Run Economic Growth Long-run economic growth The process by which rising productivity increases the average standard of living. Figure 9-1 The Growth in Real GDP per Capita, 1900– LEARNING OBJECTIVE Discuss the importance of long-run economic growth. Measured in 2005 dollars, real GDP per capital in the United States grew from about $5,600 in 1900 to about $43,700 in The average American in the year 2008 could buy nearly eight times as many goods and services as the average American in the year

7 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles The Connection between Economic Prosperity and Health Making the Connection YOUR TURN: Test your understanding by doing related problem 1.7 at the end of this chapter. 9.1 LEARNING OBJECTIVE Discuss the importance of long-run economic growth.

8 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Long-Run Economic Growth Calculating Growth Rates and the Rule of 70 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. 9.1 LEARNING OBJECTIVE Discuss the importance of long-run economic growth.

9 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Long-Run Economic Growth What Determines the Rate of Long-Run Growth? Capital Manufactured goods that are used to produce other goods and services. Increases in Capital per Hour Worked Technological Change Economic growth depends more on technological change than on increases in capital per hour worked. Technological change is an increase in the quantity of output firms can produce using a given quantity of inputs. 9.1 LEARNING OBJECTIVE Discuss the importance of long-run economic growth.

10 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Solved Problem 9-1 The Role of Technological Change in Growth Between 1960 and 1995, real GDP per capita in Singapore grew at an average annual rate of 6.2 percent. This very rapid growth rate results in the level of real GDP per capita doubling about every 11.3 years. In 1995, Alywn Young of the University of Chicago published an article in which he argued that Singapores growth depended more on increases in capital per hour worked, increases in the labor force participation rate, and the transfer of workers from agricultural to nonagricultural jobs than on technological change. If Youngs analysis was correct, predict what was likely to happen to Singapores growth rate in the years after YOUR TURN: For more practice, do related problem1.12 at the end of this chapter. 9.1 LEARNING OBJECTIVE Discuss the importance of long-run economic growth.

11 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles What Explains Rapid Economic Growth in Botswana? Making the Connection YOUR TURN: Test your understanding by doing related problem 1.14 at the end of this chapter. 9.1 LEARNING OBJECTIVE Discuss the importance of long-run economic growth. Many economists believe that the pro- growth policies of Botswanas government are the most important reason for the countrys success.

12 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Long-Run Economic Growth Potential GDP FIGURE 9-2 Actual and Potential GDP Potential GDP increases every year as the labor force and the capital stock grow and technological change occurs. The smooth red line represents potential GDP, and the blue line represents actual real GDP. During the three recessions since 1989, actual real GDP was less than potential GDP. 9.1 LEARNING OBJECTIVE Discuss the importance of long-run economic growth. Potential GDP The level of real GDP attained when all firms are producing at capacity.

13 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Saving, Investment, and the Financial System 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. Financial system The system of financial markets and financial intermediaries through which firms acquire funds from households. Discuss the role of the financial system in facilitating long-run economic growth. 9.2 LEARNING OBJECTIVE

14 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles 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 = Y + TR C T = T G TR 9.2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth.

15 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles S = (Y + TR C T) + (T G TR) S = Y C G S = I S = + or So, we can conclude that total saving must equal total investment: Saving, Investment, and the Financial System The Macroeconomics of Saving and Investment 9.2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth.

16 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles 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. 9.2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth.

17 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Demand and Supply in the Loanable Funds Market FIGURE 9-3 The Market for Loanable Funds Saving, Investment, and the Financial System The Market for Loanable Funds The demand for loanable funds is determined by the willingness of firms to borrow money to engage in new investment projects. The supply of loanable funds is determined by the willingness of households to save and by the extent of government saving or dissaving. Equilibrium in the market for loanable funds determines the real interest rate and the quantity of loanable funds exchanged. 9.2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth.

18 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Ebenezer Scrooge: Accidental Promoter of Economic Growth? Making the Connection Who was better for economic growth: Scrooge the saver or Scrooge the spender? YOUR TURN: Test your understanding by doing related problem 2.17 at the end of this chapter. 9.2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth. Savers provide the funds that are indispensable for the investment spending that economic growth requires, and the only way to save is to not consume.

19 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Explaining Movements in Saving, Investment, and Interest Rates FIGURE 9-4 An Increase in the Demand for Loanable Funds Saving, Investment, and the Financial System An increase in the demand for loanable funds increases the equilibrium interest rate from i 1 to i 2, and it increases the equilibrium quantity of loanable funds from L 1 to L 2. As a result, saving and investment both increase. 9.2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth. The Market for Loanable Funds

20 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Crowding out A decline in private expenditures as a result of an increase in government purchases. Saving, Investment, and the Financial System The Market for Loanable Funds 9.2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth. Explaining Movements in Saving, Investment, and Interest Rates

21 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles FIGURE 9-5 The Effect of a Budget Deficit on the Market for Loanable Funds Saving, Investment, and the Financial System The Market for Loanable Funds When the government begins running a budget deficit, the supply of loanable funds shifts to the left. The equilibrium interest rate increases from i 1 to i 2, and the equilibrium quantity of loanable funds falls from L 1 to L 2. As a result, saving and investment both decline. 9.2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth. Explaining Movements in Saving, Investment, and Interest Rates

22 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Solved Problem 9-2 How Would a Consumption Tax Affect Saving, Investment, the Interest Rate, and Economic Growth? YOUR TURN: For more practice, do related problem 2.16 at the end of this chapter. 9.2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth.

23 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles The Business Cycle FIGURE 9-6 The Business Cycle Some Basic Business Cycle Definitions 9.3 LEARNING OBJECTIVE Explain what happens during the business cycle. Panel (a) shows an idealized business cycle, with real GDP increasing smoothly in an expansion to a business cycle peak and then decreasing smoothly in a recession to a business cycle trough, which is followed by another expansion. The periods of expansion are shown in green, and the period of recession is shown in red. Panel (b) shows the actual movements in real GDP for 1999 to Real GDP fluctuates during the period around the business cycle peak of March The following recession was fairly short, and a business cycle trough was reached in November 2001, when the next expansion began.

24 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles PeakTrough LENGTH OF RECESSION July 1953May months August 1957April months April 1960February months December 1969November months November 1973March months January 1980July months July 1981November months July 1990March months March 2001November months December 2007 __ How Do We Know When the Economy Is in a Recession? 9.3 LEARNING OBJECTIVE Explain what happens during the business cycle. The Business Cycle Table 9-1 The U.S Business Cycle

25 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Can a Recession Be a Good Time for a Business to Expand? Making the Connection YOUR TURN: Test your understanding by doing related problem 3.7 at the end of this chapter. Businesses such as Intel viewed the recession of 2007–2009 as an opportunity to expand operations. 9.3 LEARNING OBJECTIVE Explain what happens during the business cycle. It can be difficult to commit resources to future expansion when current conditions are bleak and when the end of the recession is difficult to predict. The payoff, though, to preparing for future growth can be very large.

26 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles The Business Cycle What Happens during the Business Cycle? The Effect of the Business Cycle on Boeing Figure 9-7 The Effect of the Business Cycle on Boeing Panel (a) shows movements in real GDP for each quarter from the beginning of 1990 through the end of Panel (b) shows movements in the number of passenger aircraft shipped by Boeing for the same years. In panel (b), the effects of the recessions on Boeing are more dramatic than the effects on the economy as a whole. 9.3 LEARNING OBJECTIVE Explain what happens during the business cycle.

27 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles FIGURE 9-8 The Effect of Recessions on the Inflation Rate The Effect of the Business Cycle on the Inflation Rate The Business Cycle What Happens during the Business Cycle? Toward the end of a typical expansion, the inflation rate begins to rise. Recessions, marked by the shaded vertical bars, cause the inflation rate to fall. By the end of a recession, the inflation rate is significantly below what it had been at the beginning of the recession. 9.3 LEARNING OBJECTIVE Explain what happens during the business cycle. Dont Let This Happen to YOU! Dont Confuse the Price Level and the Inflation Rate YOUR TURN: Test your understanding by doing related problem 3.7 at the end of this chapter.

28 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles FIGURE 9-9 How Recessions Affect the Unemployment Rate The Effect of the Business Cycle on the Unemployment Rate The Business Cycle What Happens during the Business Cycle? 9.3 LEARNING OBJECTIVE Explain what happens during the business cycle. Unemployment rises during recessions and falls during expansions. The reluctance of firms to hire new employees during the early stages of a recovery means that the unemployment rate usually continues to rise even after the recession has ended.

29 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Is the Great Moderation Over? The Business Cycle What Happens during the Business Cycle? FIGURE 9-10 Fluctuations in Real GDP, 1900– LEARNING OBJECTIVE Explain what happens during the business cycle. Fluctuations in real GDP were greater before 1950 than they have been since 1950.

30 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Table 9-2 Until 2007, the Business Cycle Had Become Milder The Business Cycle PERIOD AVERAGE LENGTH OF EXPANSIONS AVERAGE LENGTH OF RECESSIONS months months19 months months10 months What Happens during the Business Cycle? 9.3 LEARNING OBJECTIVE Explain what happens during the business cycle. Is the Great Moderation Over?

31 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles The increasing importance of services and the declining importance of goods. The establishment of unemployment insurance and other government transfer programs that provide funds to the unemployed. Active federal government policies to stabilize the economy. The Business Cycle Will the U.S. Economy Return to Stability? 9.3 LEARNING OBJECTIVE Explain what happens during the business cycle. The increased stability of the financial system. Economists have offered several explanations of why the U.S. economy experienced a period of relative stability from 1950 to 2007:

32 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Airlines Face the Business Cycle and Long-Run Growth AN INSIDE LOOK >> Lower demand for air travel causes lower ticket prices and a lower quantity of tickets supplied. Airline Industry in Intensive Care

33 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick OBrien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Business cycle Capital Crowding out Financial intermediaries Financial markets Financial system Labor productivity Long-run economic growth Market for loanable funds Potential GDP KEY TERMS