13 Saving, Investment, and the Financial System PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 Financial Institutions • Financial system – Group of institutions in the economy • That help match one person’s saving with another person’s investment – Moves the economy’s scarce resources from savers to borrowers • Financial institutions – Financial markets – Financial intermediaries © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 Financial Markets • Financial markets – Savers can directly provide funds to borrowers – The bond market – The stock market © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Financial Markets • The bond market – Bond: certificate of indebtedness • Date of maturity, when the loan will be repaid • Rate of interest, paid periodically until the date of maturity • Principal, amount borrowed – Borrowing from the public • Used by large corporations, the federal government, or state and local governments © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 Financial Markets • The bond market – Term: length of time until maturity • A few months, 30 years, perpetuity • Long-term bonds are riskier than short-term bonds – Long-term bonds usually pay higher interest rates © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5 Financial Markets • The bond market – Credit risk: probability of default • Probability that the borrower will fail to pay some of the interest or principal • Higher interest rates for higher probability of default • U.S. government bonds tend to pay low interest rates • Junk bonds, very high interest rates – Issued by financially shaky corporations © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6 Financial Markets • The bond market – Tax treatment • Interest on most bonds is taxable income • Municipal bonds – Issued by state and local governments – Owners are not required to pay federal income tax on the interest income – Lower interest rate © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7 Financial Markets • The stock market – Stock: claim to partial ownership in a firm • A claim to the profits that a firm makes – Organized stock exchanges • Stock prices: demand and supply – Equity finance • Sale of stock to raise money – Stock index • Average of a group of stock prices © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8 Financial Intermediaries • Financial intermediaries – Savers can indirectly provide funds to borrowers – Banks – Mutual funds © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9 Financial Intermediaries • Banks – Take in deposits from savers • Banks pay interest – Make loans to borrowers • Banks charge interest – Facilitate purchasing of goods and services • Checks: medium of exchange © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10 Financial Intermediaries • Mutual funds – Institution that sells shares to the public – Uses the proceeds to buy a portfolio of stocks and bonds – Advantages – Diversification; professional money managers © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11 National Income Accounts • Rules of national income accounting – Important identities • Identity – An equation that must be true because of the way the variables in the equation are defined – Clarify how different variables are related to one another © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 12 Accounting Identities • Gross domestic product (GDP) – Total income – Total expenditure • Y = C + I + G + NX • • • • • Y = gross domestic product, GDP C = consumption I = investment G = government purchases NX = net exports © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 13 Accounting Identities • Closed economy – Doesn’t interact with other economies – NX = 0 • Open economy – Interact with other economies – NX ≠ 0 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 14 Accounting Identities • Assume closed economy: NX = 0 •Y=C+I+G • National saving (saving), S • Total income in the economy that remains after paying for consumption and government purchases • Y–C–G=I •S=Y–C–G •S=I © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 15 Accounting Identities • T = taxes minus transfer payments •S=Y–C–G • S = (Y – T – C) + (T – G) • Private saving, Y – T – C – Income that households have left after paying for taxes and consumption • Public saving, T – G – Tax revenue that the government has left after paying for its spending © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 16 Accounting Identities • Budget surplus: T – G > 0 – Excess of tax revenue over government spending • Budget deficit: T – G < 0 – Shortfall of tax revenue from government spending © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 17 Saving and Investing • Accounting identity: S = I • Saving = Investment – For the economy as a whole – One person’s savings can finance another person’s investment © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 18 The Market for Loanable Funds • Market for loanable funds – Market • Those who want to save supply funds • Those who want to borrow to invest demand funds – One interest rate • Return to saving • Cost of borrowing – Assumption • Single financial market © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 19 The Market for Loanable Funds • Supply and demand of loanable funds – Source of the supply of loanable funds • Saving – Source of the demand for loanable funds • Investment – Price of a loan = real interest rate • Borrowers pay for a loan • Lenders receive on their saving © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 20 The Market for Loanable Funds • Supply and demand of loanable funds – As interest rate rises • Quantity demanded declines • Quantity supplied increases – Demand curve • Slopes downward – Supply curve • Slopes upward © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 21 Figure 1 The Market for Loanable Funds Interest Rate Supply 5% Demand 0 $1,200 Loanable Funds (in billions of dollars) The interest rate in the economy adjusts to balance the supply and demand for loanable funds. The supply of loanable funds comes from national saving, including both private saving and public saving. The demand for loanable funds comes from firms and households that want to borrow for purposes of investment. Here the equilibrium interest rate is 5 percent, and $1,200 billion of loanable funds are supplied and demanded. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 22 The Market for Loanable Funds • Government policies – Can affect the economy’s saving and investment • Saving incentives • Investment incentives • Government budget deficits and surpluses © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 23 Policy 1: Saving Incentives • Shelter some saving from taxation – Affect supply of loanable funds – Increase in supply • Supply curve shifts right – New equilibrium • Lower interest rate • Higher quantity of loanable funds – Greater investment © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 24 Figure 2 Saving Incentives Increase the Supply of Loanable Funds Interest Rate Supply, S1 S2 1. Tax incentives for saving increase the supply of loanable funds . . . 5% 4% 2. . . . which reduces the equilibrium interest rate 0 ... Demand $1,200 $1,600 Loanable Funds (in billions of dollars) 3. . . . and raises the equilibrium quantity of loanable funds. A change in the tax laws to encourage Americans to save more would shift the supply of loanable funds to the right from S1 to S2. As a result, the equilibrium interest rate would fall, and the lower interest rate would stimulate investment. Here the equilibrium interest rate falls from 5 percent to 4 percent, and the equilibrium quantity of loanable funds saved and invested rises from $1,200 billion to $1,600 billion. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 25 Policy 2: Investment Incentives • Investment tax credit – Affect demand for loanable funds – Increase in demand • Demand curve shifts right – New equilibrium • Higher interest rate • Higher quantity of loanable funds – Greater saving © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 26 Figure 3 Investment Incentives Increase the Demand for Loanable Funds Interest Rate Supply 6% 5% 2. . . . which raises the equilibrium interest rate ... 1. An investment tax credit increases the demand for loanable funds . . . D2 Demand, D1 Loanable Funds $1,200 $1,400 (in billions of dollars) 3. . . . and raises the equilibrium quantity of loanable funds. 0 If the passage of an investment tax credit encouraged firms to invest more, the demand for loanable funds would increase. As a result, the equilibrium interest rate would rise, and the higher interest rate would stimulate saving. Here, when the demand curve shifts from D1 to D2, the equilibrium interest rate rises from 5 percent to 6 percent, and the equilibrium quantity of loanable funds saved and invested rises from $1,200 billion to $1,400 billion. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 27 Policy 3: Budget Deficit/Surplus • Government - starts with balanced budget – Then starts running a budget deficit • Change in supply of loanable funds • Decrease in supply – Supply curve shifts left • New equilibrium – Higher interest rate – Smaller quantity of loanable funds © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 28 Figure 4 The Effect of a Government Budget Deficit Interest Rate S2 6% 1. A budget deficit decreases the supply of loanable funds . . . 5% 2. . . . which raises the equilibrium interest rate ... Supply, S1 Demand Loanable Funds (in billions of dollars) 3. . . . and reduces the equilibrium quantity of loanable funds. 0 $800 $1,200 When the government spends more than it receives in tax revenue, the resulting budget deficit lowers national saving. The supply of loanable funds decreases, and the equilibrium interest rate rises. Thus, when the government borrows to finance its budget deficit, it crowds out households and firms that otherwise would borrow to finance investment. Here, when the supply shifts from S1 to S2, the equilibrium interest rate rises from 5 to 6 percent, and the equilibrium quantity of loanable funds saved and invested falls from $1,200 billion to $800 billion. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 29 Policy 3: Budget Deficit/Surplus • Crowding out – Decrease in investment – Results from government borrowing • Government - budget deficit – Interest rate rises – Investment falls © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 30 Policy 3: Budget Deficit/Surplus • Government – budget surplus – Increase supply of loanable funds – Reduce interest rate – Stimulates investment © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 31 The history of U.S. government debt • Debt of U.S. federal government – As a percentage of U.S. GDP – Fluctuated • 0% of GDP in 1836 • 107% of GDP in 1945 • Declining debt-to-GDP ratio – Government indebtedness is shrinking relative to its ability to raise tax revenue – Government - living within its means © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 32 The history of U.S. government debt • Rising debt-to-GDP – Government indebtedness is increasing relative to its ability to raise tax revenue • Fiscal policy cannot be sustained forever at current levels • War – primary cause of fluctuations in government debt: – Debt financing of war – appropriate policy • Tax rates – smooth over time • Shifts part of the cost to future generations © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 33 Figure 5 The U.S. Government Debt The debt of the U.S. federal government, expressed here as a percentage of GDP, has varied throughout history. Wartime spending is typically associated with substantial increases in government debt. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 34 The history of U.S. government debt • President Ronald Reagan, 1981 – Large increase in government debt – not explained by war – Committed to smaller government and lower taxes – Cutting government spending - more difficult politically than cutting taxes – Period of large budget deficits – Government debt: 26% of GDP in 1980 to 50% of GDP in 1993 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 35 The history of U.S. government debt • President Bill Clinton, 1993 – Major goal - deficit reduction – And Republicans took control of Congress in 1995: deficit reduction – Substantially reduced the size of the government budget deficit – Booming economy in the late 1990s brought in even more tax revenue – Eventually: surplus (federal budget) – By the late 1990s: debt-to-GDP ratio – declining for several years © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 36 The history of U.S. government debt • President George W. Bush – Debt-to-GDP ratio started rising again – Budget deficit • Several major tax cuts • 2001 recession - decreased tax revenue and increased government spending • Increased government spending on homeland security – Following the September 11, 2001 attacks – Subsequent wars in Iraq and Afghanistan © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 37 The history of U.S. government debt • 2008, financial crisis and deep recession – Dramatic increase in the debt-to-GDP ratio – Increased budget deficit – Several policy measures passed by the Bush and Obama administrations • Aimed at combating the recession • Reduced tax revenue • Increased government spending © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 38 The history of U.S. government debt • From 2009 to 2012 – The federal government’s budget deficit averaged about 9% of GDP • Levels not seen since World War II – The borrowing to finance these deficits • Led to the substantial increase in the debt-toGDP ratio © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 39 12 Production and Growth PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 Economic Growth • Real GDP per person – Living standard – Vary widely from country to country • Growth rate – How rapidly real GDP per person grew in the typical year • Because of differences in growth rates – Ranking of countries by income changes substantially over time © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 Table 1 The Variety of Growth Experiences © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 A Picture Is Worth a Thousand Statistics The United Kingdom is an advanced economy. In 2011, its GDP per person was $36,010. A negligible share of the population lives in extreme poverty, defined here as less than $2 a day. A baby born in the United Kingdom can expect a relatively healthy childhood: Only 5 out of 1,000 children die before reaching age 5. Educational attainment is high: Among children of high school age, 98 percent are in © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as school. 4 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A Picture Is Worth a Thousand Statistics Mexico is a middle-income country. In 2011, its GDP per person was $15,390. About 5 percent of the population lives on less than $2 a day, and 16 out of 1,000 children die before age 5. Among those of high school age, 71 percent are in school © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5 A Picture Is Worth a Thousand Statistics Mali is a poor country. In 2011, its GDP per person was only $1,040. Extreme poverty is the norm: More than three-quarters of the population lives on less than $2 per day. Life is often cut short: 176 out of 1,000 children die before age 5. And educational attainment in Mali is low: Among those of high school age, only 31 percent are in school. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6 Productivity • Productivity – Quantity of goods and services – Produced from each unit of labor input • Why productivity is so important – Key determinant of living standards – Growth in productivity is the key determinant of growth in living standards – An economy’s income is the economy’s output © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7 Productivity • Determinants of productivity – Physical capital per worker – Human capital per worker – Natural resources per worker – Technological knowledge © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8 Productivity • Physical capital – Stock of equipment and structures – Used to produce goods and services • Human capital – Knowledge and skills that workers acquire through education, training, and experience © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9 Productivity • Natural resources – Inputs into the production of goods and services – Provided by nature, such as land, rivers, and mineral deposits • Technological knowledge – Society’s understanding of the best ways to produce goods and services © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10 Are natural resources a limit to growth? • Argument – Natural resources - will eventually limit how much the world’s economies can grow • Fixed supply of nonrenewable natural resources – will run out • Stop economic growth • Force living standards to fall © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11 Are natural resources a limit to growth? • Technological progress – Often yields ways to avoid these limits • Improved use of natural resources over time • Recycling • New materials • Are these efforts enough to permit continued economic growth? © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 12 Are natural resources a limit to growth? • Prices of natural resources – Scarcity - reflected in market prices – Natural resource prices • Substantial short-run fluctuations • Stable or falling - over long spans of time – Our ability to conserve these resources • Growing more rapidly than their supplies are dwindling © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 13 Saving and Investment • Raise future productivity – Invest more current resources in the production of capital – Trade-off • Devote fewer resources to produce goods and services for current consumption © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 14 Diminishing Returns • Higher savings rate – Fewer resources – used to make consumption goods – More resources – to make capital goods – Capital stock increases – Rising productivity – More rapid growth in GDP © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 15 Diminishing Returns • Diminishing returns – Benefit from an extra unit of an input – Declines as the quantity of the input increases • In the long run, higher savings rate – Higher level of productivity – Higher level of income – Not higher growth in productivity or income © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 16 Figure 1 Illustrating the Production Function Output per Worker 1 1 2. When the economy has a high level of capital, an extra unit of capital leads to a small increase in output. 1. When the economy has a low level of capital, an extra unit of capital leads to a large increase in output. Output per Worker This figure shows how the amount of capital per worker influences the amount of output per worker. Other determinants of output, including human capital, natural resources, and technology, are held constant. The curve becomes flatter as the amount of capital increases because of diminishing returns to capital. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 17 Diminishing Returns • Catch-up effect – Countries that start off poor – Tend to grow more rapidly than countries that start off rich • Poor countries – Low productivity – Even small amounts of capital investment • Increase workers’ productivity substantially © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 18 Diminishing Returns • Rich countries – High productivity – Additional capital investment • Small effect on productivity • Poor countries – Tend to grow faster than rich countries © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 19 Investment from Abroad • Investment from abroad – Another way for a country to invest in new capital – Foreign direct investment • Capital investment that is owned and operated by a foreign entity – Foreign portfolio investment • Investment financed with foreign money but operated by domestic residents © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 20 Investment from Abroad • Benefits from investment – Some flow back to the foreign capital owners – Increase the economy’s stock of capital – Higher productivity – Higher wages – State-of-the-art technologies © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 21 Investment from Abroad • World Bank – Encourages flow of capital to poor countries – Funds from world’s advanced countries – Makes loans to less developed countries • Roads, sewer systems, schools, other types of capital – Advice about how the funds might best be used © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 22 Investment from Abroad • World Bank and the International Monetary Fund – Set up after World War II – Economic distress leads to: • Political turmoil, international tensions, and military conflict – Every country has an interest in promoting economic prosperity around the world © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 23 Education • Education – Investment in human capital – Gap between wages of educated and uneducated workers – Opportunity cost: wages forgone – Conveys positive externalities – Public education - large subsidies to human-capital investment • Problem for poor countries: Brain drain © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 24 Health and Nutrition • Human capital – Education – Expenditures that lead to a healthier population • Healthier workers – More productive • Wages – Reflect a worker’s productivity © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 25 Health and Nutrition • Right investments in the health of the population – Increase productivity – Raise living standards • Historical trends: long-run economic growth – Improved health – from better nutrition – Taller workers – higher wages – better productivity © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 26 Health and Nutrition • Vicious circle in poor countries – Poor countries are poor • Because their populations are not healthy – Populations are not healthy • Because they are poor and cannot afford better healthcare and nutrition © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 27 Health and Nutrition • Virtuous circle – Policies that lead to more rapid economic growth – Would naturally improve health outcomes – Which in turn would further promote economic growth © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 28 Property Rights, Political Stability • To foster economic growth – Protect property rights • Ability of people to exercise authority over the resources they own • Courts – enforce property rights – Promote political stability • Property rights – Prerequisite for the price system to work © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 29 Property Rights, Political Stability • Lack of property rights – Major problem – Contracts are hard to enforce – Fraud goes unpunished – Corruption • Impedes the coordinating power of markets • Discourages domestic saving • Discourages investment from abroad © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 30 Property Rights, Political Stability • Political instability – A threat to property rights – Revolutions and coups – Revolutionary government might confiscate the capital of some businesses – Domestic residents - less incentive to save, invest, and start new businesses – Foreigners - less incentive to invest © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 31 Free Trade • Inward-oriented policies – Avoid interaction with the rest of the world – Infant-industry argument • Tariffs • Other trade restrictions – Adverse effect on economic growth © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 32 Free Trade • Outward-oriented policies – Integrate into the world economy – International trade in goods and services – Economic growth • Amount of trade – determined by – Government policy – Geography • Easier to trade for countries with natural seaports © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 33 Research and Development • Knowledge – public good – Government – encourages research and development • Farming methods • Aerospace research (Air Force; NASA) • Research grants – National Science Foundation – National Institutes of Health • Tax breaks • Patent system © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 34 Population Growth • Large population – More workers to produce goods and services • Larger total output of goods and services – More consumers • Stretching natural resources – Malthus: an ever-increasing population • Strain society’s ability to provide for itself • Mankind - doomed to forever live in poverty © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 35 Population Growth • Diluting the capital stock – High population growth • Spread the capital stock more thinly • Lower productivity per worker • Lower GDP per worker • Reducing the rate of population growth – Government regulation – Increased awareness of birth control – Equal opportunities for women © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 36 Population Growth • Promoting technological progress – World population growth • Engine for technological progress and economic prosperity • More people = More scientists, more inventors, more engineers © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 37 12 Production and Growth PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 Economic Growth • Real GDP per person – Living standard – Vary widely from country to country • Growth rate – How rapidly real GDP per person grew in the typical year • Because of differences in growth rates – Ranking of countries by income changes substantially over time © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 Table 1 The Variety of Growth Experiences © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 A Picture Is Worth a Thousand Statistics The United Kingdom is an advanced economy. In 2011, its GDP per person was $36,010. A negligible share of the population lives in extreme poverty, defined here as less than $2 a day. A baby born in the United Kingdom can expect a relatively healthy childhood: Only 5 out of 1,000 children die before reaching age 5. Educational attainment is high: Among children of high school age, 98 percent are in © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as school. 4 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A Picture Is Worth a Thousand Statistics Mexico is a middle-income country. In 2011, its GDP per person was $15,390. About 5 percent of the population lives on less than $2 a day, and 16 out of 1,000 children die before age 5. Among those of high school age, 71 percent are in school © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5 A Picture Is Worth a Thousand Statistics Mali is a poor country. In 2011, its GDP per person was only $1,040. Extreme poverty is the norm: More than three-quarters of the population lives on less than $2 per day. Life is often cut short: 176 out of 1,000 children die before age 5. And educational attainment in Mali is low: Among those of high school age, only 31 percent are in school. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6 Productivity • Productivity – Quantity of goods and services – Produced from each unit of labor input • Why productivity is so important – Key determinant of living standards – Growth in productivity is the key determinant of growth in living standards – An economy’s income is the economy’s output © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7 Productivity • Determinants of productivity – Physical capital per worker – Human capital per worker – Natural resources per worker – Technological knowledge © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8 Productivity • Physical capital – Stock of equipment and structures – Used to produce goods and services • Human capital – Knowledge and skills that workers acquire through education, training, and experience © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9 Productivity • Natural resources – Inputs into the production of goods and services – Provided by nature, such as land, rivers, and mineral deposits • Technological knowledge – Society’s understanding of the best ways to produce goods and services © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10 Are natural resources a limit to growth? • Argument – Natural resources - will eventually limit how much the world’s economies can grow • Fixed supply of nonrenewable natural resources – will run out • Stop economic growth • Force living standards to fall © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11 Are natural resources a limit to growth? • Technological progress – Often yields ways to avoid these limits • Improved use of natural resources over time • Recycling • New materials • Are these efforts enough to permit continued economic growth? © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 12 Are natural resources a limit to growth? • Prices of natural resources – Scarcity - reflected in market prices – Natural resource prices • Substantial short-run fluctuations • Stable or falling - over long spans of time – Our ability to conserve these resources • Growing more rapidly than their supplies are dwindling © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 13 Saving and Investment • Raise future productivity – Invest more current resources in the production of capital – Trade-off • Devote fewer resources to produce goods and services for current consumption © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 14 Diminishing Returns • Higher savings rate – Fewer resources – used to make consumption goods – More resources – to make capital goods – Capital stock increases – Rising productivity – More rapid growth in GDP © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 15 Diminishing Returns • Diminishing returns – Benefit from an extra unit of an input – Declines as the quantity of the input increases • In the long run, higher savings rate – Higher level of productivity – Higher level of income – Not higher growth in productivity or income © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 16 Figure 1 Illustrating the Production Function Output per Worker 1 1 2. When the economy has a high level of capital, an extra unit of capital leads to a small increase in output. 1. When the economy has a low level of capital, an extra unit of capital leads to a large increase in output. Output per Worker This figure shows how the amount of capital per worker influences the amount of output per worker. Other determinants of output, including human capital, natural resources, and technology, are held constant. The curve becomes flatter as the amount of capital increases because of diminishing returns to capital. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 17 Diminishing Returns • Catch-up effect – Countries that start off poor – Tend to grow more rapidly than countries that start off rich • Poor countries – Low productivity – Even small amounts of capital investment • Increase workers’ productivity substantially © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 18 Diminishing Returns • Rich countries – High productivity – Additional capital investment • Small effect on productivity • Poor countries – Tend to grow faster than rich countries © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 19 Investment from Abroad • Investment from abroad – Another way for a country to invest in new capital – Foreign direct investment • Capital investment that is owned and operated by a foreign entity – Foreign portfolio investment • Investment financed with foreign money but operated by domestic residents © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 20 Investment from Abroad • Benefits from investment – Some flow back to the foreign capital owners – Increase the economy’s stock of capital – Higher productivity – Higher wages – State-of-the-art technologies © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 21 Investment from Abroad • World Bank – Encourages flow of capital to poor countries – Funds from world’s advanced countries – Makes loans to less developed countries • Roads, sewer systems, schools, other types of capital – Advice about how the funds might best be used © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 22 Investment from Abroad • World Bank and the International Monetary Fund – Set up after World War II – Economic distress leads to: • Political turmoil, international tensions, and military conflict – Every country has an interest in promoting economic prosperity around the world © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 23 Education • Education – Investment in human capital – Gap between wages of educated and uneducated workers – Opportunity cost: wages forgone – Conveys positive externalities – Public education - large subsidies to human-capital investment • Problem for poor countries: Brain drain © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 24 Health and Nutrition • Human capital – Education – Expenditures that lead to a healthier population • Healthier workers – More productive • Wages – Reflect a worker’s productivity © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 25 Health and Nutrition • Right investments in the health of the population – Increase productivity – Raise living standards • Historical trends: long-run economic growth – Improved health – from better nutrition – Taller workers – higher wages – better productivity © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 26 Health and Nutrition • Vicious circle in poor countries – Poor countries are poor • Because their populations are not healthy – Populations are not healthy • Because they are poor and cannot afford better healthcare and nutrition © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 27 Health and Nutrition • Virtuous circle – Policies that lead to more rapid economic growth – Would naturally improve health outcomes – Which in turn would further promote economic growth © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 28 Property Rights, Political Stability • To foster economic growth – Protect property rights • Ability of people to exercise authority over the resources they own • Courts – enforce property rights – Promote political stability • Property rights – Prerequisite for the price system to work © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 29 Property Rights, Political Stability • Lack of property rights – Major problem – Contracts are hard to enforce – Fraud goes unpunished – Corruption • Impedes the coordinating power of markets • Discourages domestic saving • Discourages investment from abroad © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 30 Property Rights, Political Stability • Political instability – A threat to property rights – Revolutions and coups – Revolutionary government might confiscate the capital of some businesses – Domestic residents - less incentive to save, invest, and start new businesses – Foreigners - less incentive to invest © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 31 Free Trade • Inward-oriented policies – Avoid interaction with the rest of the world – Infant-industry argument • Tariffs • Other trade restrictions – Adverse effect on economic growth © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 32 Free Trade • Outward-oriented policies – Integrate into the world economy – International trade in goods and services – Economic growth • Amount of trade – determined by – Government policy – Geography • Easier to trade for countries with natural seaports © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 33 Research and Development • Knowledge – public good – Government – encourages research and development • Farming methods • Aerospace research (Air Force; NASA) • Research grants – National Science Foundation – National Institutes of Health • Tax breaks • Patent system © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 34 Population Growth • Large population – More workers to produce goods and services • Larger total output of goods and services – More consumers • Stretching natural resources – Malthus: an ever-increasing population • Strain society’s ability to provide for itself • Mankind - doomed to forever live in poverty © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 35 Population Growth • Diluting the capital stock – High population growth • Spread the capital stock more thinly • Lower productivity per worker • Lower GDP per worker • Reducing the rate of population growth – Government regulation – Increased awareness of birth control – Equal opportunities for women © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 36 Population Growth • Promoting technological progress – World population growth • Engine for technological progress and economic prosperity • More people = More scientists, more inventors, more engineers © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 37 13 Saving, Investment, and the Financial System PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 Financial Institutions • Financial system – Group of institutions in the economy • That help match one person’s saving with another person’s investment – Moves the economy’s scarce resources from savers to borrowers • Financial institutions – Financial markets – Financial intermediaries © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 Financial Markets • Financial markets – Savers can directly provide funds to borrowers – The bond market – The stock market © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Financial Markets • The bond market – Bond: certificate of indebtedness • Date of maturity, when the loan will be repaid • Rate of interest, paid periodically until the date of maturity • Principal, amount borrowed – Borrowing from the public • Used by large corporations, the federal government, or state and local governments © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 Financial Markets • The bond market – Term: length of time until maturity • A few months, 30 years, perpetuity • Long-term bonds are riskier than short-term bonds – Long-term bonds usually pay higher interest rates © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5 Financial Markets • The bond market – Credit risk: probability of default • Probability that the borrower will fail to pay some of the interest or principal • Higher interest rates for higher probability of default • U.S. government bonds tend to pay low interest rates • Junk bonds, very high interest rates – Issued by financially shaky corporations © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6 Financial Markets • The bond market – Tax treatment • Interest on most bonds is taxable income • Municipal bonds – Issued by state and local governments – Owners are not required to pay federal income tax on the interest income – Lower interest rate © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7 Financial Markets • The stock market – Stock: claim to partial ownership in a firm • A claim to the profits that a firm makes – Organized stock exchanges • Stock prices: demand and supply – Equity finance • Sale of stock to raise money – Stock index • Average of a group of stock prices © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8 Financial Intermediaries • Financial intermediaries – Savers can indirectly provide funds to borrowers – Banks – Mutual funds © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9 Financial Intermediaries • Banks – Take in deposits from savers • Banks pay interest – Make loans to borrowers • Banks charge interest – Facilitate purchasing of goods and services • Checks: medium of exchange © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10 Financial Intermediaries • Mutual funds – Institution that sells shares to the public – Uses the proceeds to buy a portfolio of stocks and bonds – Advantages – Diversification; professional money managers © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11 National Income Accounts • Rules of national income accounting – Important identities • Identity – An equation that must be true because of the way the variables in the equation are defined – Clarify how different variables are related to one another © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 12 Accounting Identities • Gross domestic product (GDP) – Total income – Total expenditure • Y = C + I + G + NX • • • • • Y = gross domestic product, GDP C = consumption I = investment G = government purchases NX = net exports © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 13 Accounting Identities • Closed economy – Doesn’t interact with other economies – NX = 0 • Open economy – Interact with other economies – NX ≠ 0 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 14 Accounting Identities • Assume closed economy: NX = 0 •Y=C+I+G • National saving (saving), S • Total income in the economy that remains after paying for consumption and government purchases • Y–C–G=I •S=Y–C–G •S=I © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 15 Accounting Identities • T = taxes minus transfer payments •S=Y–C–G • S = (Y – T – C) + (T – G) • Private saving, Y – T – C – Income that households have left after paying for taxes and consumption • Public saving, T – G – Tax revenue that the government has left after paying for its spending © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 16 Accounting Identities • Budget surplus: T – G > 0 – Excess of tax revenue over government spending • Budget deficit: T – G < 0 – Shortfall of tax revenue from government spending © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 17 Saving and Investing • Accounting identity: S = I • Saving = Investment – For the economy as a whole – One person’s savings can finance another person’s investment © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 18 The Market for Loanable Funds • Market for loanable funds – Market • Those who want to save supply funds • Those who want to borrow to invest demand funds – One interest rate • Return to saving • Cost of borrowing – Assumption • Single financial market © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 19 The Market for Loanable Funds • Supply and demand of loanable funds – Source of the supply of loanable funds • Saving – Source of the demand for loanable funds • Investment – Price of a loan = real interest rate • Borrowers pay for a loan • Lenders receive on their saving © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 20 The Market for Loanable Funds • Supply and demand of loanable funds – As interest rate rises • Quantity demanded declines • Quantity supplied increases – Demand curve • Slopes downward – Supply curve • Slopes upward © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 21 Figure 1 The Market for Loanable Funds Interest Rate Supply 5% Demand 0 $1,200 Loanable Funds (in billions of dollars) The interest rate in the economy adjusts to balance the supply and demand for loanable funds. The supply of loanable funds comes from national saving, including both private saving and public saving. The demand for loanable funds comes from firms and households that want to borrow for purposes of investment. Here the equilibrium interest rate is 5 percent, and $1,200 billion of loanable funds are supplied and demanded. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 22 The Market for Loanable Funds • Government policies – Can affect the economy’s saving and investment • Saving incentives • Investment incentives • Government budget deficits and surpluses © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 23 Policy 1: Saving Incentives • Shelter some saving from taxation – Affect supply of loanable funds – Increase in supply • Supply curve shifts right – New equilibrium • Lower interest rate • Higher quantity of loanable funds – Greater investment © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 24 Figure 2 Saving Incentives Increase the Supply of Loanable Funds Interest Rate Supply, S1 S2 1. Tax incentives for saving increase the supply of loanable funds . . . 5% 4% 2. . . . which reduces the equilibrium interest rate 0 ... Demand $1,200 $1,600 Loanable Funds (in billions of dollars) 3. . . . and raises the equilibrium quantity of loanable funds. A change in the tax laws to encourage Americans to save more would shift the supply of loanable funds to the right from S1 to S2. As a result, the equilibrium interest rate would fall, and the lower interest rate would stimulate investment. Here the equilibrium interest rate falls from 5 percent to 4 percent, and the equilibrium quantity of loanable funds saved and invested rises from $1,200 billion to $1,600 billion. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 25 Policy 2: Investment Incentives • Investment tax credit – Affect demand for loanable funds – Increase in demand • Demand curve shifts right – New equilibrium • Higher interest rate • Higher quantity of loanable funds – Greater saving © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 26 Figure 3 Investment Incentives Increase the Demand for Loanable Funds Interest Rate Supply 6% 5% 2. . . . which raises the equilibrium interest rate ... 1. An investment tax credit increases the demand for loanable funds . . . D2 Demand, D1 Loanable Funds $1,200 $1,400 (in billions of dollars) 3. . . . and raises the equilibrium quantity of loanable funds. 0 If the passage of an investment tax credit encouraged firms to invest more, the demand for loanable funds would increase. As a result, the equilibrium interest rate would rise, and the higher interest rate would stimulate saving. Here, when the demand curve shifts from D1 to D2, the equilibrium interest rate rises from 5 percent to 6 percent, and the equilibrium quantity of loanable funds saved and invested rises from $1,200 billion to $1,400 billion. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 27 Policy 3: Budget Deficit/Surplus • Government - starts with balanced budget – Then starts running a budget deficit • Change in supply of loanable funds • Decrease in supply – Supply curve shifts left • New equilibrium – Higher interest rate – Smaller quantity of loanable funds © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 28 Figure 4 The Effect of a Government Budget Deficit Interest Rate S2 6% 1. A budget deficit decreases the supply of loanable funds . . . 5% 2. . . . which raises the equilibrium interest rate ... Supply, S1 Demand Loanable Funds (in billions of dollars) 3. . . . and reduces the equilibrium quantity of loanable funds. 0 $800 $1,200 When the government spends more than it receives in tax revenue, the resulting budget deficit lowers national saving. The supply of loanable funds decreases, and the equilibrium interest rate rises. Thus, when the government borrows to finance its budget deficit, it crowds out households and firms that otherwise would borrow to finance investment. Here, when the supply shifts from S1 to S2, the equilibrium interest rate rises from 5 to 6 percent, and the equilibrium quantity of loanable funds saved and invested falls from $1,200 billion to $800 billion. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 29 Policy 3: Budget Deficit/Surplus • Crowding out – Decrease in investment – Results from government borrowing • Government - budget deficit – Interest rate rises – Investment falls © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 30 Policy 3: Budget Deficit/Surplus • Government – budget surplus – Increase supply of loanable funds – Reduce interest rate – Stimulates investment © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 31 The history of U.S. government debt • Debt of U.S. federal government – As a percentage of U.S. GDP – Fluctuated • 0% of GDP in 1836 • 107% of GDP in 1945 • Declining debt-to-GDP ratio – Government indebtedness is shrinking relative to its ability to raise tax revenue – Government - living within its means © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 32 The history of U.S. government debt • Rising debt-to-GDP – Government indebtedness is increasing relative to its ability to raise tax revenue • Fiscal policy cannot be sustained forever at current levels • War – primary cause of fluctuations in government debt: – Debt financing of war – appropriate policy • Tax rates – smooth over time • Shifts part of the cost to future generations © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 33 Figure 5 The U.S. Government Debt The debt of the U.S. federal government, expressed here as a percentage of GDP, has varied throughout history. Wartime spending is typically associated with substantial increases in government debt. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 34 The history of U.S. government debt • President Ronald Reagan, 1981 – Large increase in government debt – not explained by war – Committed to smaller government and lower taxes – Cutting government spending - more difficult politically than cutting taxes – Period of large budget deficits – Government debt: 26% of GDP in 1980 to 50% of GDP in 1993 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 35 The history of U.S. government debt • President Bill Clinton, 1993 – Major goal - deficit reduction – And Republicans took control of Congress in 1995: deficit reduction – Substantially reduced the size of the government budget deficit – Booming economy in the late 1990s brought in even more tax revenue – Eventually: surplus (federal budget) – By the late 1990s: debt-to-GDP ratio – declining for several years © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 36 The history of U.S. government debt • President George W. Bush – Debt-to-GDP ratio started rising again – Budget deficit • Several major tax cuts • 2001 recession - decreased tax revenue and increased government spending • Increased government spending on homeland security – Following the September 11, 2001 attacks – Subsequent wars in Iraq and Afghanistan © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 37 The history of U.S. government debt • 2008, financial crisis and deep recession – Dramatic increase in the debt-to-GDP ratio – Increased budget deficit – Several policy measures passed by the Bush and Obama administrations • Aimed at combating the recession • Reduced tax revenue • Increased government spending © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 38 The history of U.S. government debt • From 2009 to 2012 – The federal government’s budget deficit averaged about 9% of GDP • Levels not seen since World War II – The borrowing to finance these deficits • Led to the substantial increase in the debt-toGDP ratio © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 39
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