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
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2
Financial Markets
• Financial markets
– Savers can directly provide funds to
borrowers
– The bond market
– The stock market
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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
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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
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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
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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
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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
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8
Financial Intermediaries
• Financial intermediaries
– Savers can indirectly provide funds to
borrowers
– Banks
– Mutual funds
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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
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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
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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
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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
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13
Accounting Identities
• Closed economy
– Doesn’t interact with other economies
– NX = 0
• Open economy
– Interact with other economies
– NX ≠ 0
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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
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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
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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
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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
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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
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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
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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
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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.
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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
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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
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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.
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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
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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.
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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
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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.
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29
Policy 3: Budget Deficit/Surplus
• Crowding out
– Decrease in investment
– Results from government borrowing
• Government - budget deficit
– Interest rate rises
– Investment falls
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30
Policy 3: Budget Deficit/Surplus
• Government – budget surplus
– Increase supply of loanable funds
– Reduce interest rate
– Stimulates investment
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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
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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
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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.
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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
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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
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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
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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
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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
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39
12
Production and Growth
PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
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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
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2
Table 1
The Variety of Growth Experiences
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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
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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
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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.
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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
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7
Productivity
• Determinants of productivity
– Physical capital per worker
– Human capital per worker
– Natural resources per worker
– Technological knowledge
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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
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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
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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
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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?
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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
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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
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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
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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
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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.
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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
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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
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8
Financial Intermediaries
• Financial intermediaries
– Savers can indirectly provide funds to
borrowers
– Banks
– Mutual funds
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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
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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
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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
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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
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13
Accounting Identities
• Closed economy
– Doesn’t interact with other economies
– NX = 0
• Open economy
– Interact with other economies
– NX ≠ 0
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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
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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
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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
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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
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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
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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
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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
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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.
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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
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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
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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.
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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
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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.
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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
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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.
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29
Policy 3: Budget Deficit/Surplus
• Crowding out
– Decrease in investment
– Results from government borrowing
• Government - budget deficit
– Interest rate rises
– Investment falls
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30
Policy 3: Budget Deficit/Surplus
• Government – budget surplus
– Increase supply of loanable funds
– Reduce interest rate
– Stimulates investment
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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
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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
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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.
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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
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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
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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
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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
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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
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