ECON1220 Introductory Macroeconomics Tutorial #3 PDF

ECON1220 Introductory Macroeconomics TUTORIAL #3 1  Long – Run Economic Growth The process by which rising productivity increases the average standard of living. The best measure of the standard of living is real GDP pe...

ECON1220 Introductory Macroeconomics TUTORIAL #3 1  Long – Run Economic Growth The process by which rising productivity increases the average standard of living. The best measure of the standard of living is real GDP per person, which is usually called real GDP per capita. Example of Factors Driving Long-Run Economic Growth: 1. Physical Capital: The stock of equipment, machinery, and infrastructure in a country. Investment in physical capital, such as factories, machinery, and roads, can lead to increased production capabilities. 2. Human Capital: The skills, knowledge, and experience possessed by individuals. Investment in education, training, and healthcare can enhance the productivity of workers. 3. Technological Advancements: Innovations and improvements in technology can lead to increased production efficiency. This includes advancements in information technology, manufacturing processes, and research methodologies. 4. Natural Resources: Availability and efficient utilization of natural resources like minerals, oil, and fertile land can significantly impact growth, especially for resource-rich countries. 5. Institutional Factors: Stable political systems, a strong rule of law, property rights, and efficient bureaucracies can create an environment conducive to economic growth. 6. Entrepreneurship: The presence of individuals who are willing to take risks to start new businesses can drive innovation and job creation. 7. Trade and Globalization: Openness to international trade can lead to market expansion, access to technology, and increased competition, which can foster growth. 8. Research and Development (R&D): Investment in R&D can lead to new product development and innovations that can spur growth. 3 Growth Rate The growth rate of real GDP or real GDP per capita during a particular year is equal to the percentage change from the previous year. Growth rate = Real GDP Current year - Real GDP previous year x 100 Real GDP previous year 4  Rule of 70 70 Number of years to double = Growth Rate Eg. How many years to double if the growth rate is 35%? Eg. If you want to double your wealth in 10 years, what should be the growth rate? These examples illustrate an important point: Small differences in growth rates can have large effects on how rapidly the standard of living in a country increases. Also notice that the rule of 70 applies not just to growth in real GDP per capita but to growth in any variable. For example, if you invest $1,000 in the stock market, and your investment grows at an average annual rate of 7 percent, your investment will double to $2,000 in 10 years. Few more examples of how we can use the Rule of 70: 1. Economic Growth: If a country's GDP is growing at an annual rate of 3.5%, the Rule of 70 estimates that the country's GDP will double in approximately: 20 years 2. Population Growth: If a city's population is growing at an annual rate of 2%, it will take: 35 years for the city's population to double. 3. Investment Returns: Suppose you have an investment that earns an annual interest rate of 7%. Using the Rule of 70, your investment will double in: 10 years 4. Decline in Value: if a resource is depleting at a rate of 5% per year, it will take: 14 years for the resource to be halved. (Note: While the rule is commonly used for growth, it can also be applied to declining values.) 5 Potential GDP The level of real GDP attained when all firms are producing at capacity. Potential GDP increases when the labor force, capital stock grow and technological change occurs 6 Financial System The system of financial markets and financial intermediaries through which firms acquire funds from households. Channels funds from savers to borrowers Channels returns on the borrowed funds back to savers 7 Financial system Financial markets: Where financial securities, such as stocks and bonds, are bought and sold. Financial intermediaries: Firms, such as banks, mutual funds, pension funds, and insurance companies, that borrow funds from savers and lend them to borrowers. Financial security: a document states the terms under which funds pass from the buyer of the security to the seller. 8 Liquidity Liquidity is the ease with which a form of financial security can be exchanged for another without reducing it’s value. 9 Saving & Investment In a closed economy, I=Y–C–G Sprivate = Y + TR – C – T Spublic = T – G – TR S = Sprivate + Spublic S=Y–C–G S=I 10 Saving and Investment Spublic = T – G – TR Balanced budget: Spublic = 0 Budget deficit: Spublic < 0 (dissaving) Budget surplus: Spublic >0 11  Importance of Saving and Investment for Economic Growth: 1. Capital Formation: Savings provide the funds necessary for investments in capital goods. These capital goods (like machinery, infrastructure, and technology) increase the productive capacity of an economy, leading to higher output and income. 2. Technological Progress: Investment often involves the adoption of new technologies. As firms invest in new machinery and equipment, they often incorporate the latest technologies, leading to productivity improvements. 3. Job Creation: Investment projects, such as infrastructure development or the establishment of new factories, create jobs. This leads to increased income and further boosts savings and consumption. 4. Increased Income: As investments yield returns, they lead to increased income for both individuals and the nation. This can further stimulate consumption and economic growth. 5. Stability and Confidence: A high rate of national savings can provide economic stability. It reduces a country's dependence on foreign capital, making it less vulnerable to external shocks. Moreover, high savings can instill confidence among investors, both domestic and foreign.  The Market for Loanable Funds The interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged. The demand for loanable funds is determined by the willingness of firms to borrow money to engage in new investment projects. The supply of loanable funds is determined by the willingness of households to save and by the extent of government saving or dissaving. Equilibrium in the market for loanable funds determines the real interest rate and the quantity of loanable funds exchanged. 12 Loanable funds market When loanable funds market is in equilibrium (in a closed economy): I=S Sp = Private savings = Disposable income – Consumption = (Y – T + TR) – C Sg = Public savings = Taxes – Government Spending – Transfer payment = T – G - TR Total savings in the economy: S = Sp + Sg S= [(Y – T + TR) – C ] + [T – G – TR] S=Y–C–G Since in a closed economy Y = C + I + G S=C+I+G–C–G S=I The intersection between S and I schedules will determine the equilibrium r* and L 11  Loanable funds market Supply of Loanable Funds = S The amount saved depends on the consumption function, as households allocate a portion of their disposable income to consumption and the remainder to savings in each period. Current consumption is influenced by: 1. Real Interest Rate: An increase in the real interest rate (r) raises the opportunity cost of consuming today, leading to a decrease in current consumption and an increase in savings. This results in an upward-sloping supply curve for loanable funds, indicating a positive relationship between r and the quantity of loanable funds supplied. Conversely, a decrease in the interest rate stimulates consumption, reduces savings, and therefore decreases the supply of loanable funds. 2. Income stream: a) Current Income: A $1 increase in income will lead to an increase in consumption by the Marginal Propensity to Consume (MPC) and an increase in saving by the Marginal Propensity to Save (MPS). b) Expected Future Income: An anticipated rise in future income can lead to an increase in current consumption due to households’ preference for smooth consumption over time. If current income remains unchanged and consumption increases, the amount saved will decrease."  Loanable funds market Demand for Loanable Funds = I (in a closed economy) The demand for loanable funds originates from firms and households that wish to make real investments. Investment and Capital: I = Ke – (1 - δ) K Here, K_e represents the desired capital stock based on the expected return on capital (MPK) and the cost of borrowing (r). Therefore, the level of investment (I) also depends on MPK and r. As r increases, borrowing becomes more expensive, which will reduce the expected profits from investments. Consequently, firms will be less inclined to borrow. This establishes a negative relationship between r and the quantity of loanable funds, resulting in a downward-sloping demand curve for loanable funds. Factors shifting loanable fund supply Factors shifting loanable fund demand Nominal vs Real interest rate Nominal interest rate: the stated interest rate on a loan Real interest rate: corrects the nominal interest rate for the effect of inflation and is equal to the nominal interest rate minus the inflation rate 13 Increase in profitability in investment 14 Increase in government budget deficit 15 Crowding out Crowding out refers to a decline in investment spending as a result of an increase in government purchases. There are several possible reasons for this, for example: 1. Higher Interest Rates: When the government borrows more, it can lead to an increase in interest rates. As interest rates rise, borrowing costs for private entities also increase, making some investment projects unviable. 2. Limited Resources: If the government increases its spending on goods and services, it might use up resources (like labor or materials) that the private sector would have used, leading to increased costs for private firms. 16 17 18 Business Cycle Expansion phase: Production increase Employment increase Income increase Recession phase: Production decline Employment decline Income decline 19 Solow Growth Model Does not seek to explain technological change instead treating it as the result of chance scientific discovery. predicts the catch-up the level of GDP per capita in poor countries will grow faster than rich countries. New Growth Theory Paul Romer Emphasizes that technological change is influenced by economic incentives and so is determined by the working of the market system. accumulation of knowledge capital is a key determinant of economic growth Public good Increasing returns (at the economy level) Creative Destruction Joseph Schumpeter The entrepreneur is central to economic growth; and the profits of entrepreneurs provide the incentive for bringing together the factors of production—labor, capital, and natural resources—in new ways. Exercise: MCs 1) If real GDP per capita doubles between 2005 and 2020, what is the average annual growth rate of real GDP per capita? A) 4.7% B) 10.5% C) 15% D) 21% 20 Exercise: MCs 2. The only way the standard of living of the average person in a country can increase is if increases faster than. a. production; population b. population; GDP per capita c. population; production d. population; income 21 Exercise: MCs 3. Suppose that real GDP for 2012 was $10,000 billion and real GDP for 2013 was $11,000 billion. What is the rate of growth of real GDP between 2012 and 2013? a. 1% b. 2% c. 5% d.10% 22 Exercise: MCs 4. What is investment in a closed economy if you have the following economic data? Y = $10 trillion C = $5 trillion TR = $2 trillion G = $2 trillion a. $2 trillion b. $3 trillion c. $5 trillion d. cannot be determined without information on taxes (T) 23 Exercise: MCs 5. The demand for loanable funds is downward sloping because the the interest rate, the the number of profitable investment projects a firm can undertake, and the the quantity demanded of loanable funds. a. lower; greater; greater b. lower; smaller; greater c. greater; greater; greater d. greater; smaller; greater 24 Exercise: MCs Figure 10-3 6) Refer to Figure 10-3. Which of the following is consistent with the graph depicted above? a. Taxes are changed so that real interest income is taxed rather than nominal interest income. b. An expected recession decreases the profitability of new investment. c. The government runs a budget deficit. d. Technological change increases the profitability of new investment. 25 Exercise: MCs 7. How would the equilibrium quantity of loanable funds respond to a change from an income tax to a consumption tax? a. The equilibrium quantity of loanable funds would rise. b. The equilibrium quantity of loanable funds would fall. c. The equilibrium quantity of loanable funds would be unaffected. d. The equilibrium quantity of loanable funds may rise or fall based on whether household saving increases or decreases as a result of the change from an income tax to a consumption tax. 26 Exercise: MCs 8 If, in a closed economy, real GDP is $30 billion, consumption is $20 billion, and government purchases are $5 billion, what is total saving in the economy? a. $5 billion b. $15 billion c. $45 billion d. $55 billion 27 Exercise: MCs 9. An increase in the government budget deficit will shift the curve for loanable funds to the and the equilibrium real interest rate will. a. supply; right; fall b. supply; left; rise c. demand; right; rise d. demand; left; fall 28 Exercise: MCs 10) Inflation tends to during the expansion phase of the business cycle and during the recession phase of the business cycle. a. increase; decrease b. decrease; increase c. decrease; decrease further d. increase; increase further 29 Answers: MCs 1. A 10. A 2. A 3. D 4. B 5. A 6. A 7. A 8. A 9. B 30