1. PRODUCTION and
GROWTH
Mankiw, Chapter 25
Krugman, Chapter 25

2. Comparing Economies Across Time and Space
*Krugman

3. U.S. Real GDP per Capita
*Krugman

4. Income Around the World
*Krugman

5. 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

6. Average Annual Growth Rates of Real GDP per Capita, 1975–2003
*Krugman

7. The Sources of Long-Run Growth - Definitions:
Labor productivity
Physical capital
Human capital
Technology
*Krugman

8. *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.

9. 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 = A F(L, K, H, N)
Y = quantity of output
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.

10. 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).

11. 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

12. Physical Capital and Productivity
*Krugman

13. Average GDP Per Person grows about 2% per year.
This means Average GDP Per Person doubles every 35 years.

14. Technological Progress and Productivity Growth
*Krugman

15. 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.
One way to raise future productivity is to invest more current resources in the production of capital.

16. In short, a higher savings rate increases productivity.
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.

17. 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.

18. 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)

19. 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.

20. What happens when they get there and they don’t want to go back?
Encourage education and training
EDUCATION is a positive externality.
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….
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?

21. 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.

22. Encourage Free Trade
Some of the poorest countries have tried to gain economic growth by using inward-oriented 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.

23. 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.

24. 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.

25. Poor Countries Regulate Business the Most…
*Krugman

26. Success, Disappointment, and Failure
*Krugman

27. 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

28. Economics in Action: Are economies converging?
*Krugman

29. SAVING AND INVESTMENT IN THE NATIONAL INCOME ACCOUNTS
Taken from Mankiw Ch 26
Krugman Ch 26

30. The Savings–Investment Spending Identity in a Closed Economy
In a closed economy: GDP = C + I + G
SPrivate = GDP + TR − T − C
SGovernment = T − TR − G
NS = SPrivate + SGovernment = (GDP + TR − T − C) + (T − TR − G)
= GDP − C − G
Hence, I = NS
Investment spending = National savings in a closed economy
*Krugman

31. 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 + NX

32. Some Important Identities
Assume a closed economy – one that does not engage in international trade:
Y = C + I + G

33. 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).

34. Some Important Identities
Substituting S for Y - C - G, the equation can be written as:
S = I

35. Some Important Identities
National saving, or saving, is equal to:
S = I
S = Y – C – G
S = (Y – T – C) + (T – G)

36. 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)

37. 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)

38. 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.

39. The Meaning of Saving and Investment
For the economy as a whole, saving must be equal to investment.
S = I

40. Budget Surplus and Budget Deficit
*Krugman

41. The Savings–Investment Spending Identity in an Open Economy
I = SPrivate + SGovernment + (IM – X) = NS + KI (10)
Investment spending = National savings + Capital inflow in an open economy
*Krugman

42. The Savings-Investment Spending Identity in Open Economies: the United States and Japan 2003
*Krugman

43. THE MARKET FOR LOANABLE FUNDS
Financial markets coordinate the economy’s saving and investment in the market for loanable funds.

44. 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.

45. 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.

46. 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.

47. 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.

48. 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.

49. Supply and Demand for Loanable Funds
Government Policies That Affect Saving and Investment
Taxes and saving
Taxes and investment
Government budget deficits
*Mankiw

50. The Demand for Loanable Funds
*Krugman

51. The Supply for Loanable Funds
*Krugman

52. The Market for Loanable Funds
Interest
Rate
Supply
Demand 5%
$1,200
Loanable Funds
(in billions of dollars)
*Mankiw
Copyright©2004 South-Western

53. Equilibrium in the Loanable Funds Market
*Krugman

54. Savings, Investment Spending, and Government Policy
*Krugman

55. Increasing Private Savings
*Krugman

56. 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.

57. 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.

58. An Increase in the Supply of Loanable Funds
Interest
Supply, S1 S2
Rate
Demand
1. Tax incentives for
saving increase the
supply of loanable
fund
s . . . 5%
$1,200 2.
. . . which
reduces the
equilibrium
interest rat
e . . . 4%
$1,600
Loanable Funds 3.
. . . and raises the equilibrium
quantity of loanable funds.
(in billions of dollars)
Copyright©2004 South-Western

59. Policy 1: Saving Incentives
If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment.

60. 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.

61. Policy 2: Investment Incentives
If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving.

62. An Increase in the Demand for Loanable Funds
Interest
Rate
Supply D2
1. An investment
tax credit
increases the
demand for
loanable fund
s . . .
Demand, D1 6%
$1,400 2.
. . . which
raises the
equilibrium
interest rate . . . 5%
$1,200
Loanable Funds 3.
. . . and raises the equilibrium
quantity of loanable funds.
(in billions of dollars)
Copyright©2004 South-Western

63. 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.

64. 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.

65. 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.

66. The Effect of a Government Budget Deficit
Interest S2
Supply, S1
Rate
Demand
1. A budget deficit
decreases the
supply of loanable
fund
s . . .
$800 6% 2.
. . . which
raises the
equilibrium
interest rat
e . . .
$1,200 5%
Loanable Funds 3.
. . . and reduces the equilibrium
quantity of loanable funds.
(in billions of dollars)
Copyright©2004 South-Western

67. Policy 3: Government Budget Deficits and Surpluses
When government reduces national saving by running a deficit, the interest rate rises and investment falls.

68. Policy 3: Government Budget Deficits and Surpluses
A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment.

69. The U.S. Government Debt Percent of GDP 120 World War II 100 80 60
Revolutionary
War
Civil
War
World War I 40 20
1790
1810
1830
1850
1870
1890
1910
1930
1950
1970
1990
2010
Copyright©2004 South-Western

70. The Financial System - Definitions
Wealth
Financial asset
Physical asset
Liability
Transaction costs
Financial risk
*Krugman

71. Risk-Averse Attitudes Toward Gain and Loss
*Krugman

72. Three Tasks of a Financial System
Reducing transaction costs
Reducing financial risk
Providing liquid assets
*Krugman

73. 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

74. *Krugman

75. 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.

76. 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.

77. 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.

78. 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.