ECON1201 PDF - Measuring the State of the Economy

Measuring the state of the economy Accounting helps keep track of stock of resources in given entity ○ Stock --> amount of resources Ie total output/ capital stock ○ It shows the flow variables contributing --> resources per unit of time...

Measuring the state of the economy Accounting helps keep track of stock of resources in given entity ○ Stock --> amount of resources Ie total output/ capital stock ○ It shows the flow variables contributing --> resources per unit of time Ie consumption, investment, imports and exports per quarter We learn about the future of the economy by studying the past --> helps shape better models/forecasting/ view on economic growth and allocation of resources Measuring GDP Allows for the comparison of countries of economic output Conventional measure for the state of a economy is gross domestic product (GDP) ○ GDP is the market value of the final good and services measured by the end of a given period of time IE account for all cars, massages, concerts so on These goods must have a market ie paper trial / tax records Add their value for the year You get a measure of GDP There are 3 ways to approach GDP calculations 1. Expenditure items (flows) a. All sold in the markets, either as domestic or exports 2. Income ie through tax a. Would measure the sums of all wages, profits 3. Production ie through sells a. Would measure sum of all iteams produced Expenditure approach to GDP The expenditure measure of GDP counts the total purchase if goods and services in the economy Government transfers are not included ie social security, Medicare, unemployment insurance --> as it no new production Income approach The income approach measures the sum of all income earned in the economy Income appears as ○ Wage/ salary ○ Worker benefits (health, dental) ○ Economic profits (net operating surplus of businesses) ○ Depreciation of 'capital' Another way to visualize national income: Classify all income figures as either labor or capital This is an artificial construct If we imagine it --> the data produces the following empirical regularity The total share of GDP in terms if labor income is approx 2/3 (long run average) The total share of GDP of capital is approx. 1/3 Labour share of GDP has remained around a constant average over time Production Approach Sum of the value of goods and services produced in an economy over a given period Not precise enough Principle: no double counting of value of production Measurement Concept: value added ○ The amount each producer in the economy contributes to GDP ○ The revenue generated by each producer minus the vale of intermediate products So more precisely, GDP (production) measures the total of value added Also, only new production of goods and services count towards this approach of measuring GDP Only Goods and services that are transacted through markets are included in GDP Does not included ○ Government transfer payments ○ Social security ○ A measure if health of people ○ Changes in environment Changes Over time Nominal GDP Economic activity in current market value or money terms We deal with the problem of inflation and changes in money value over time to construct Price indexes We contract measures of real GDP Calculating Real GDP changes over time Laspeyres index --> calculates changes in real GDP using the initial prices Paasche index --> calculates changes in real GDP using the final year prices Over the long time intervals the two indexes can result in substantial difference The fisher index (chain weighting) is the preferred approach to calculating real GDP Property of this index ○ A weight average of the Laspeyres and Pasche index Preferred because ○ Takes account obsolescence and new products New goods/services are invented While other become obsolete Can be applied on a year by year if we compute real GDP each year Comparative economic performance The exchange rate: price at which different currencies are traded Cross country GDP: figures must be expressed in common currency by first adjusting it by the exchange rate Summary Inflation and Money Inflation: a generalized rise in the overall level of prices Also described as ○ Rise in the cost of living ○ A decline in purchasing power of money Not every price change is a sign of inflation Measure of inflation There are many measures of inflation Consumer price index (CPI) An index that tracks the average price consumers pay overtime for a representative basket of goods and services How to calculate inflation Challenges of measuring the true cost of living CPI likely overstates changes in the cost of living because it tracks the changing price of a fixed basket of goods. 1. Quality improvements can hide price decreases. ○ Measured rise in prices is likely due to unmeasured quality improvements. Example: iPhones are now more expensive relative to the first model. 2. Doesn’t account for the reduction in the cost of living due to the introduction of new products. ○ iPhone replaced many goods and services on which people previously spent lots of money.  3.When prices rise, you substitute what’s in your basket to find cheaper ways to achieve the same quality of life ○ CPI’s fixed basket of goods doesn’t capture substitution across items. ○ Substitution bias: the overestimate of the cost of living that occurs because people substitute toward goods whose prices rise by less. Key take aways: measuring inflation Inflation: a generalized rise in the overall level of prices. Using the CPI to measuring inflation: 1. Find out what people buy and construct a representative basket. 2. Collect prices from the stores where people do their shopping. 3. Tally up the cost of the basket. 4. Calculate the inflation rate: the % increase in the average price level. The CPI’s measure of the inflation people experience is imperfect Different measures of inflation Consumer prices CPI is the most popular measure of inflation, but different measures of inflation which consider different baskets of goods and services can be relevant for different tasks. The CPI is used for cost-of-living adjustments: ○ Indexation clause in employment contracts. ○ The government also indexes the Aged Pension and other welfare payments so that they are automatically adjusted for inflation. Core inflation used by forecasters to examine the underlying trend in inflation: ○ Excludes food and fuel because their prices are often volatile. Business prices Producer price index (PPI): A price index that tracks the prices of inputs into the production process. Helps businesses see how the prices that matter to them are changing. GDP deflator: A price index that tracks the prices of all goods and services produced domestically Used when adjusting the dollar amounts describing what the economy produces. Used to convert nominal GDP to real GDP Adjusting for the Effects of Inflation Comparing dollars over time Use the inflation adjustment formula to adjust for changing prices. Convert dollar amounts from the past into today’s dollar amounts. Real and nominal variables  inflation can distort comparisons from different time periods. Real and nominal interest rates The benefits and costs of saving or borrowing money are impacted by inflation. Overcoming money illusion Money illusion: the (mistaken) tendency to focus on nominal dollar amounts instead of inflation-adjusted amounts. Money illusion can: Distort decisions. What if all prices throughout the economy (including incomes) rose by 25%? Lead to mis-pricing. Make sure you correctly value your home that you bought few years ago. Create nominal wage rigidity. Employers often choose to stick with last year’s wage. Money illusion leads workers to feel okay, even though their real wage fell. Key take away: different measures of inflation The Role of Money and the Costs of Inflation Money: Money is any asset regularly used in transactions Money services three key functions: Medium of exchange Unit of account Store of value Function 1: Money is a medium of exchange Used as a medium of exchange whenever you… Hand it over to buy stuff. Accept it from your employer in exchange for your work. Without the medium you Make everything yourself Barter for things you want/ need Money creates opportunities for you to specialize Focus on tasks where your skills are most valuable, and then spend the money you earn to buy a smartphone from Apple, or a pizza from a local restaurant Function 2: Money is a unit of account. Money is a common unit that people use to measure economic value. Architects use metresto describe distance. We use dollars to describe prices and record debts  A common unit simplifies comparisons and trade-offs: If apples cost $2 a kilogram and oranges cost $3 a kilogram, then you know you must give up more apples to get a kilogram of oranges. The common unit should be a stable unit of account: If the architects measuring tape were to shrink or expand each day, it wouldn’t be useful. Function 3: Money is a store of value When you save money, you are using money as a store of value. Shift your wealth to the future (perhaps for retirement). Other options ○ Storing gold brinks ○ Art ○ Canned food But these aren't ideal store of. Value as price can fluctuate and difficult to store Money successfully functions as a store of value when Easy to store Holds it value The costs of inflation: Inflation undermines the productive benefit of money: When inflation is low and stable, then money serves its three functions well. High or unpredictable inflation erodes the functions of money. Hyperinflation Extreme high rates of inflation No agreed upon point at which inflation becomes classidied as hyperinflation Rare Example: ○ German hyperinflation of 1922–1923 saw prices double every few days. ○ Venezuela has recently struggled with hyperinflation. Hyperinflation can make life harder and erodes all functions of money ○ Venezuelan bolivar lost its value too quickly to function as a store of value or unit of account and made it an unattractive medium of exchange The costs of expected inflation Inflation goal of 2% to 3% inflation can stabilize at the same rate as people come to expect a certain level of inflation. But even expected inflation can have costs Cost 1: Inflation creates menu costs for sellers. Menu costs: the marginal cost of adjusting prices. Businesses devote valuable resources to reprinting menus, adjusting price tags, and reprograming vending machines more often. inflation made money an unstable unit of account A higher price better covers the rising costs of your inputs this year ○ The marginal benefit of raising your price exceeds the marginal cost of adjusting the price Cost 2: Inflation creates shoe-leather costs for buyers. Shoe-leather costs: the costs incurred trying to avoid holding cash. Inflation undermines money’s function as a store of value People are spending time trying to keep their wealth in assets that better maintain their value. As prices rise, the cash in your wallet (or in your PayPal or checking accounts) becomes worth less. You don’t want to store your wealth in money (i.e., you don’t want to hold money). This means spending money quickly or trying to move money around to preserve its value. The costs of unexpected inflation Cost 3: Inflation confuses the signals that prices send. Prices help coordinate economic activity Quinoa example: An increased price signals producers that buyers want more quinoa Incentivizes producers to expand quinoa production. But if inflation is causing all prices to rise, there’s no reason to expand production. Producers make mistakes interpreting price changes! Inflation undermines the stability of dollars as a unit of account. This instability confounds the signals that price sends. Cost 4: Inflation redistributes. Unexpected inflation redistributes from savers and lenders toward borrowers. Most loans specify repayment schedules in nominal terms. Unexpected inflation changes the real value of the repayments Example You borrow $15,000 to buy a car at a 5% nominal interest rate, the repayment schedule commits you to pay $283 per month for the next 5 years. If inflation is higher than expected, you keep paying $283 per month even though the dollars you send the bank aren’t worth as much. Hurts lenders and helps borrowers! The inflation fallacy Inflation fallacy: the mistaken belief that inflation destroys purchasing power. Inflation means all prices are rising, including the price of labour (i.e., wages and salaries). If prices and wages rise together, then purchasing power is roughly unchanged. The inflation fallacy reflects a psychological bias: People are quick to blame inflation for higher prices. But interpret a rise in their nominal wages as an earned reward for their hard work. Role of Central Banks Central banks in many advanced economies set explicit inflation targets. (2-3%) Use monetary policy to achieve price stability. Keeping inflation low and stable is a priority. However, low unemployment and moderate long-term interest rates are also important goals, as is stability of the financial system Central bank independence is important. Central banks and monetary policy Central banks conduct monetary policy by adjusting the supply of money – buying or selling securities on open market Open market operations affect short-term interest rates, which in turn influence longer-term rates. When central banks lower interest rates, monetary policy is easing. When they raise interest rates, monetary policy is tightening. The RBA targets the cash rate, which is the rate charged on overnight loans between commercial banks. This is transmitted to long term rates. Interest rates and economic activity In a nutshell, lower interest rates promote spending by consumers and investment by firms. A boost in aggregate demand pushes prices up, all else equal. The effects of monetary policy depend on many factors, including inflation expectations – If individuals expect inflation, they ask for higher wages, pushing up inflation. – For monetary policy to be most effective, best to have low stable inflation with inflation expectations kept in check. Limited monetary policy tools when interest rate close to zero Factors Influencing Inflation Demand- pull (excess demand puts pressure on prices)  Could be from consumers, government, or net exports. Firms increase supply – higher labor demand, higher wages. Prices rise. 2. Cost-push (input costs and supply related) Aggregate supply falls. E.g., price of imported inputs rises (e.g., oil). Natural disasters. Disruptions of supply chains. If long lasting, can lead to “stagflation” – high inflation combined with stagnant growth or recession. 3. Inflation expectations ‘inflation psychology’; firms increase prices and workers demand higher wages if they expect high inflation. This leads to inflation to actually happen. Uneven effects of inflation Unanticipated inflation reduces real value of nominal claims and redistributes wealth from lenders to borrowers. ○ borrowers are younger on average than lenders ○ inflation generates a decrease in labor supply as well as an increase in savings The poor hold more cash relative to other financial assets (access to credit is costly) – hence they are hurt more by inflation ○ Inflation is a regressive consumption tax ○ The poor have low bargaining power to set inflation, and suffer more leads to substantial redistribution The main losers from inflation are rich, old households, the major bondholders in the economy. The main winners are young, middle-class households with fixed-rate mortgage debt.” Inflation is a boon for the government and a tax on foreigners Unanticipated inflation benefits government because government is a large debtor Uneven effects of inflation Some wages and salaries increase more rapidly than the price level while others more slowly Some asset prices increase more rapidly than the price level while others more slowly Is Deflation Bad? (yes) Deflation is when prices decrease over time, and purchasing power increases (opposite of inflation). Are the effects of inflation and deflation symmetric? Potential causes: lower demand or higher supply. Temporary price declines due to a strong expansion in aggregate supply, falling import prices, or higher productivity are generally not problematic. Aggregate demand-driven deflation is a problem, especially if long lasting.  People will delay purchases to buy things cheaper later Debt becomes more expensive – firms will be reluctant to borrow so investment declines Lower spending means lower revenue for producers, which means lower labor demand and potential rise in unemployment and lower wages Feedback loop: higher unemployment and lower wages lowers demand for goods, so prices decline further. Usually deflation is associated with big downturns. – The Great Depression Deflation in Japan Intro the growth Economic growth brings wealth, which increases societal well-being Wealthier nations have: ○ Higher infant survival rates, ○ life expectancy, and nutrition ○ More educational opportunities, leisure, and entertainment ○ Fewer conflicts such as civil wars and riots ○ More material goods Key Facts: about the wealth of nations and economic growth: 1. GDP per capita varies enormously among nations. 2. Everyone used to be poor. 3. There are growth miracles and growth disasters GDP per Capita Varies Most of the world's population is poor relative to the United States. About 760 million people in 2019 live in a country with a GDP per capita of less than $4,000. About 70% of the world's population lives in countries with a GDP per capita equal to or less than $14,000, about the level in China. About 76% of the world's population lives in countries with a GDP per capita less than the average. Everyone Used to Be Poor The distribution of world income tells us that poverty is normal, while wealth is unusual. GDP per capita in year 1 is estimated around $700–$1,000 per year in 2015 dollars. This was approximately the same in all major regions of the world. For most of recorded human history, there was no long-run growth in real per capita GDP. Today, GDP per capita is 50 times larger in the richest countries than in the poorest. Economic growth since 1 million B.C There was very little progress for most of human history. ○ Hand-to-mouth as hunters and gatherers. Transitioned to farming, but starvation and malnutrition were still common. From 1 million B.C. until 1200 C.E. GDP per person was around $200 per year. At the start of the 1800s, world real GDP per person was roughly $400 per year. Zooming in on the past 200 years A Primer on Growth Rates Economic growth is measured as the growth rate of real GDP per capita. Even slow growth, sustained over time, produces big differences in wealth. Growth builds on top of growth through "compounding" or "exponential growth." RULE OF 70 Growth Miracles The United States is one of the world's wealthiest countries because it grew slowly but consistently for more than 200 years. From 1950 to 1970, Japan grew 8.5% per year. ○ – Now it's one of the richest countries in the world. In 1950, South Korea had GDP per capita about the same as that of Nigeria. ○ From 1970 to 1990, it grew at a rate of 7.2% per year. ○ Today, South Korea is on par with many European economies. Growth Disasters Nigeria has barely grown since 1950. ○ It was poorer in 2005 than in 1974, when high oil prices briefly bumped up its per capita GDP. In 1900, Argentina was one of the richest countries in the world, with GDP per capita almost as large as that of the United States. ○ By 1950, Argentina's per capita GDP had fallen to half that of the United States. ○ By 2000, Argentina's per capita GDP was less than onethird that of the United States. The Wealth of Nations The causes of growth in GDP per capita include factors of production, incentives, and institutions Definitions Physical capital: The stock of tools that include machines, structures, and equipment  Human capital: The productive knowledge and skills that workers acquire through education, training, and experience Technological knowledge: The knowledge about how the world works that is used to produce goods and services. Institutions: The "rules of the game" that structure economic Incentives. Free rider: Someone who consumes a resource without working or contributing to the resource's upkeep. Economies of scale: The advantages of large-scale production that reduce average cost as quantity increases Factors of Production Countries with a high GDP per capita have a lot of factors of production: physical capital, human capital, and technological knowledge. More and better physical capital makes workers more productive. Human capital enables workers to take advantage of more sophisticated tools. Greater quantities of physical and human capital per worker make workers more productive. We increase human capital with education improved technological knowledge increases productivity and is potentially boundless. Better technological knowledge has allowed U.S. farms to increase their output two and a half times since 1950, and while using less land. We increase technological knowledge with research and development. The organization of factors of production depends on incentives and institutions. Incentives and Institutions Institutions include laws and regulations, but also customs, practices, organizations, and social mores. Institutions that promote growth create incentives that align self-interest with the social interest. Wealthy countries have institutions that make it in people's self-interest to invest in physical capital, human capital, and technological knowledge. Institutions of economic growth include: ○ Property rights Property rights are important institutions for encouraging investment in physical and human capital. Under communal property, effort is divorced from payment, so there is incentive to free ride. When China switched from communal to individual farms, food production increased by 50%, and 170 million people were lifted above the lowest poverty line.  Savers won't save and investors won't invest if they don't expect that they will receive a return for their savings and investment. Property rights are also important for encouraging technological innovation. Companies will not undertake research and development unless they expect to profit from it ○ Honest government Corruption is like a tax that bleeds resources away from productive entrepreneurs. Resources "invested" in bribing cannot be invested in machinery and equipment. Corruption makes it more profitable to be a corrupt politician or bureaucrat. Few people want to be entrepreneurs because they know that their wealth will be stolen. ○ Political stability In many nations, civil war, military dictatorships, and anarchy have destroyed the institutions necessary for economic growth. Prior to 2006, two Liberian presidents used force to eradicate their opposition for 35 years. ○ A dependable legal system A good legal system facilitates contracts and protects private parties from expropriating one another. Poorly protected property rights can stem from either too much or too little government. Some legal systems are of such low quality that no one knows for certain who owns what. It is difficult to borrow money if lenders aren't sure they will get their money back ○ Competitive and open markets About half the differences in per capita income across countries are explained by differences in the amount of physical and human capital. The other half of the differences are explained by a failure to use capital efficiently. Competitive and open markets are one of the best ways to encourage the efficient organization of resources. Some reasons for inefficient organization include: Inefficient and unnecessary regulations Red tape, or the time and cost to do tasks such as starting a business or enforcing a contract in a court of law  Barriers to free trade Ultimate Causes of Wealth Natural resources may help explain why a country is able to accumulate physical and human capital. Transport is cheaper over water than over land, so countries with access to water are more open to trade. Landlocked countries have lower per capita GDP than countries with access to a coast. History, ideas, geography, culture, and luck are also important to economic growth History of recessions Early 1990s recession ○ Worst recession since Great Depression ○ 1987 stock market crash ○ This recession helped reduce inflation expectations, making it easier to keep it low and constant afterwards. ○ Following this, a record period of growth. Global Financial Crisis ○ The very large Australian gov. stimulus package helped prevent a recession. Also helped by booking Chinese economy and mining boom. Pandemic recession ○ Substantial fiscal and monetary policy support measures were introduced ○ Shifts in consumer preferences –increase in online commerce, home delivery and digital services; working from home, lower demand for commercial office and retail space. Demographic Change and Economic Growth Rapid population aging could slow down growth significantly: ○ Aging created excess savings relative to investment ○ An older population will reduce labor force participation and productivity (consider also % young people required to care for old) ○ Fewer ideas generates as population shrinks (Jones (2022) The End of Economic Growth? Unintended Consequences of a Declining Population) After 1990, labor-replacing technologies (robotics and AI) allowed firms to automate the production process, replacing workers.  ○ countries undergoing more rapid demographic change are more likely to adopt robots ○ “when capital is sufficiently abundant, a shortage of younger and middle-aged workers can trigger so much more adoption of new automation technologies that the negative effects of labor scarcity could be completely neutralized or even reversed.” Aside: Do labor shortages spur productivity? Following the Covid-19 recession, tight labor markets: 2 job vacancies per unemployed worker in early 2022. Costs of labor increased (employers have to raise wages to attract workers) do firms substitute away from labor to capital? tight labor markets lead firms to adopt automation technologies, leading to higher productivity – this is true for industries that employ routine manual tasks. Industries relying on nonroutine tasks saw productivity declines because of the tight labor market. Technology adoption and increased productivity is expected to lower prices in long-run. What measure to use when faced with demographic shifts? Economists often determine policy (monetary and fiscal) trying to maximize economic growth (among other things, e.g., lower inequality, stability, etc) If we consider GDP/capita, this can give wrong implications for policy. Demographic change needs to be considered. Policies affect working age population (e.g., migration and fertility policies) ○ Canada and US have had high immigration – working age population grew by 29-31% from 1991-2019. ○ In contrast, working age populations of Italy and Germany declined by 2%. GDP/capita the right measure if we focus on welfare growth. ○ Important to consider for public debt and social security sustainability GDP/worker a better measure if we are concerned with productivity. Growth and Inequality ( 2 views) View 1 - Inequality is good for incentives and growth: the marginal propensity to save of the rich is higher than that of the poor. (Stiglitz (1969), Bourguignon (1981)). Higher savings rates may promote growth Innovations often involve large sunk costs, so we need wealth to be concentrated Incentive considerations; effort. (Mirrlees (1971)). Taxation needed for redistribution will lower the rate of return, discouraging saving and investment, lowering growth (these imply a fundamental trade-off btw efficiency (growth) and equality.) View 2 - Equality is good for incentives and growth: discourage unproductive investments by rich increase human capital held by poor demand patterns by poor (biased to local goods) political instability improves borrowers’ incentives Growth and Inequality – Evidence Negative correlation between the average rate of growth and measures of inequality (Benabou (1996)) ○ e.g. South Korea and the Philippines (the latter had higher inequality and had much slower growth). ○ In 1960, they looked very similar, but Philippines had greater inequality. (top 20/bottom 40 wealth x2 in Phil.) ○ Over next 30 yrs, S. Korea grew x5, while Philippines only x2. greater inequality reduces the rate of growth (Alesina and Rodrick (1994), Perotti (1992, 1993, 1996), and Persson and Tabellini (1994).) Redistribution policies found to have mainly positive effects on growth (Easterly and Robelo (1993), Perotti (1996)). Growth and Inequality feedback mechanisms ○ Redistribution reduces inequality, which accelerates growth, further reducing inequality ○ Growth increases inequality, calling for permanent redistribution efforts. inverted U-shaped relation between income inequality and GNP per head. ○ Transition from rural to industrial economy. Initially, inequality increases with development, then it falls after most industrialization took place. ○ Up to the 1970’s, U-shape pattern held for most OECD countries. ○ BUT, after 1970s, reversal observed. Wage inequality increased tremendously 3 Reasons why inequality may be detrimental for growth: Reason 1 (. Inequality and investments) » If individuals are limited in their borrowing capacity, the distribution of wealth affects their production possibilities Aggregate productivity and growth improved by redistributing wealth from the rich (with low Marginal Productivity of investments) to the poor (with high Marginal Productivity but who cannot access credit) A tax on the wealthy and redistribution to less wealthy will have +ve effects.  Greater credit availability has positive effects on growth rate. (More physical capital investment. Positive spillover effects Reasons 2 (Inequality and borrowers’ incentives) ex-ante moral hazard - source of credit-market imperfections limited liability - effort exerted by borrowers investing in risky project is lower than what lenders would choose. redistributing wealth towards borrowers will have a positive effect on their effort incentives. Effort increases if the personal wealth being risked for an investment project is higher.. Inequality and Macro Volatility Higher income inequality is associated with greater growth volatility, which is in turn associated with lower average growth rates. Volatility implies dynamic inefficiencies. Timing of physical and human capital investments can be delayed when there is higher volatility. Structural reforms such as investing in infrastructure or in human capital, or reducing the bureaucratic obstacles faced by entrepreneurs that wish to set up a firm, would reduce entry barriers and promote growth. Definitions Cutting-edge growth: Growth due to new ideas ○ Ie the U.S economy Catching-up growth: Growth due to capital accumulation. ○ IE the china economy Marginal product of capital: The increase in output caused by the addition of one more unit of capital. The marginal product of capital diminishes as more and more capital is added Steady-state level of capital: When the capital stock is neither increasing nor Decreasing Conditional convergence: The tendency—among countries with similar steady-state levels of output—for poorer countries to grow faster than richer countries and thus for poor and rich countries to converge in income. Non-rivalrous: When one person’s consumption of a good does not limit another person’s consumption. The Solow Model and Catching-Up Growth The Solow model begins with a production function  The total output of an economy (Y) depends on ○ : – Physical capital (K) ○ – Human capital, or education × Labor (eL) ○ – Ideas (A) A production function expresses a relationship between output and the factors of production: Y = F(A, K, eL) we assume that A, e, and L are constant, then we can simplify our expression for output as: ○ Y = F(K) More capital (K) should produce more output (Y), but at a diminishing rate. Because L is constant: ○ An increase in K always implies an increase in the amount of capital per worker, K/L. ○ An increase in Y is also always an increase in output per worker, Y/L The Solow Model: Capital, Production, and Diminishing Returns More capital (K) should produce more output (Y) but at a diminishing rate. The MPK diminishes because the first unit of capital is applied where it is most productive, the second unit where it is slightly less productive, and so on. The following graph shows the production function Y = F(K). In this case, output is the square root of the capital input K. If K = 4, then Y = = 4 2. If K = 14, then Y = = 16 4 Growth in China and the United States Chinese growth has been rapid for the following reasons: ○ China began with very little capital, so its marginal product of capital was high. ○ With new reforms, the investment rate increased dramatically. ○ China has benefited by opening up to trade and investment with the developed world. ○ China has improved its productivity in agriculture China’s growth rate will eventually fall for the following reasons ○ The marginal product of capital will fall. ○ It has a poor banking system. ○ It lacks experience with the rule of law. ○ It has a poorly educated population. Consumption and investment Capital and Investment Capital is output that is saved and invested rather than consumed. For example, out of 10 units produced, 7 are consumed and 3 are invested in new capital.  We write the fraction of output that is invested in new capital as gamma (ɣ). In the example just given, ɣ = 3/10 = 0.3. Capital also depreciates (wears out). For example, if there are 100 units of capital, 2 units might depreciate, leaving 98 for the next period Capital and Depreciation We write the fraction of capital that wears out or depreciates as delta (δ). In the example just given, δ = 2/100 = 0.02. The greater the capital stock, the greater the depreciation. This places another constraint on economic growth. Steady-State Level of Capital As the capital stock gets larger, investment increases but at a diminishing rate. Depreciation, however, increases with the capital stock at a linear (constant) rate. At some point, investment = depreciation. This is the steady-state level of capital. There is no new (net) investment, and economic growth stops. Catching-Up Growth Long-run economic growth cannot be due to capital accumulation. Diminishing returns means that eventually capital and output will cease growing. The logic of diminishing returns applies to human capital as well. Changes in the capital stock drive output, so when Investment = Depreciation and K is at its steady-state level, then so is output. The Investment Rate the Solow model, a greater investment rate means more capital, which means more output. This increases a country’s steady-state level of GDP. Thus, the Solow model predicts that countries with higher rates of investment will be wealthier. The level of the capital stock determines the output level but not its growth rate, at least not in the very long run. GDP per capita is higher in countries with higher investment rates Conditional Convergence The tendency—among countries with similar steady-state levels of output—for poorer countries to grow faster than richer countries and thus for poor and rich countries to converge in income.  The following figure uses data from 18 of the 20 founding members of the OECD (Organization for Economic Co-operation and Development). Over time, the OECD countries have converged to a similar level of GDP per capita. The poorer a country was in 1960, the faster its growth was between 1960 and 2000 Cutting-Edge Growth The simplest form of the Solow model predicts zero economic growth in the long run. The United States, however, has been growing for more than 200 years. Better ideas can keep the economy growing even in the long run. A computer today has about the same amount of silicon and labor input as 20 years ago, but today’s computer is much better—the difference is ideas A stands for ideas that increase productivity; our production function is: ○ Y=AsqrtK Better ideas or technological knowledge ○ as represented by increases in A ○ increase output even while holding K constant. In other words, an increase in A represents an increase in productivity The Economics of Ideas Ideas for increasing output are primarily researched, developed, and implemented by profit-seeking firms. Ideas can be freely shared, but spillovers mean that ideas are underprovided. Government has a role in improving the production of ideas. The larger the market, the greater the incentive to research and develop new ideas. Research for Profit Institutions and incentives drive the generation of technological knowledge. These institutions include: ○ A setting that helps innovators to connect with capitalists ○ Intellectual property rights ○ A high-quality educational system The United States has a very good cultural and commercial infrastructure for supporting new ideas and their commercialization. Patents New processes, products, and methods can be copied by competitors. Imitators have lower costs and tend to drive innovators out of the market unless barriers prevent quick imitation. Patents give innovators temporary monopoly rights, typically 20 years. Patents increase the incentive to develop new products, but they also increase monopoly power. Monopoly power raises prices and slows the spread of innovations throughout the economy.  The trade-off between creating incentives for R&D while avoiding too much monopoly power is one of the trickiest in economic policy. Spillovers Even with patents, ideas tend to spill over and benefit other firms and consumers. Since ideas are non-rivalrous and many can be shared at low cost, they should be shared. However, if the originator doesn’t get enough of the benefits, ideas will be underprovided. Economists know that idea spillovers are good; they also know that spillovers mean that too few good ideas are produced in the first place Government’s Role The government can increase the incentive to produce new ideas through patents. The government can also encourage the production of new ideas through subsidies or tax breaks. Universities train scientists who research and develop new products. The large spillovers to basic science suggest a role for government subsidies to universities. Market Size Larger markets mean increased incentives to invest in research and development As countries become wealthier, companies will increase their worldwide R&D investments. The Future of Economic Growth Growth in per capita world GDP has been increasing. Worldwide per capita GDP is currently growing by a little more than 3% per year. The number of new ideas is a function of the number of people, the incentives to innovate, and the number of ideas per hour that each person has. A(ideas) = Population × Incentives × Ideas per hour The number of people in the world is increasing. As the world gets richer, the number of people whose job it is to produce new ideas is increasing. Because of spillovers, these ideas will benefit everyone. Increased consumer wealth and integrated markets boost the incentive to innovate. Economic growth might be even faster in the future than it has been in the past. Schumpeterian Growth Theory Schumpeter’s “creative destruction:” new innovations replace existing ones which are rendered obsolete over time. (e.g. Netflix led to the decline of cable TV and movie theatres)  ○ newer and better innovations drive out worse ones ○ importance of economic dynamism ○ questions of how to regulate technologies ○ issues of inequality: those committed to old technologies lose, while entrepreneurs and workers in the new technology gain. ○ Entrepreneurship is critical (i) the role of competition and market structure » Growth and Industrial Organization » faster innovation leads to higher turnover rates of firms and jobs » Competition is positively associated with growth. Patent policy important. (ii) firm dynamics » small firms exit more frequently than large firms. If they survive, small firms grow faster (iii) the relationship between growth and development; appropriate growth institutions ○ different types of policies or institutions appear to be growth-enhancing at different stages of development ○ The relationship btw growth and democracy is stronger in more frontier economies (iv) the emergence and impact of long-term technological waves. ○ More firm entry and exit; ○ could initially generate a productivity slowdown » Increase wage inequality Basic Schumpeterian growth model growth is generated by innovations innovations arise from entrepreneurial investments motivated by the prospects of monopoly rents new innovations replace old technologies Growth in this model: innovations improve the quality of the intermediate input used in the production of the final good Once a better technology comes along, old firms producing intermediate inputs using old technologies are driven out of business. Empirical Evidence positive correlation between growth and product market competition (in other growth models, no relationship, or even negative relationship (Romer)) ○ competition and entry stimulate innovation and productivity growth by incumbent firms (at frontier, neck-and neck) ○ competition and productivity growth display an inverted-U relationship ○ patent protection encourages R&D investments and innovation Growth meets development: “growth-enhancing policies or institutions may vary with a country’s level of technological development” role of democracy: matters for growth to a larger extent in more advanced economies  The process of diffusion, or technology spillover, is an important factor behind cross-country convergence a country that starts far behind the world technology frontier can grow faster (Howitt (2000)) Need different institutions: to help a country copy, adapt, and implement leading-edge technologies. These are different from those fuelling leading-edge innovations Acemoglu et al. (2006): ○ » explore relationship btw average growth rate and a country’s distance to the US frontier ○ » Look at two groups: more and less open countries (than median) 1. Countries close to the frontier have growth driven by innovation-enhancing rather than imitation-enhancing policies and institutions 2. “Openness is particularly growth-enhancing in countries that are closer to the technological frontier” 3. Free entry is more growth-enhancing in countries or sectors that are closer to the technological frontier 4. Higher education is more growth-enhancing in countries closer to the technological frontier; primary-secondary education is more growth enhancing in countries farther below the frontier. 5. The correlation between democracy and innovation/growth is more positive and significant in more frontier economies General general-purpose technologies (GPTs), 3 predictions of model technological innovation that affects production and/or innovation in many sectors of an economy (e.g., steam engine, electricity, IT revolution) 1. Pervasive and have large macro effects 2. Tend to underperform when first introduced Require costly restructuring and adjustment to take place A positive tech shock could reduce output, productivity, and employment Need critical mass of intermediate components accumulated before profitable for firms to switch from the previous GPT 3. Make it easier to invent new products and processes General general-purpose technologies (GPTs), 3 predictions of model: “The diffusion of a new GPT is associated with an increase in the flow of firm entry and exit.” 2. “The arrival of a new GPT generates a slowdown in productivity growth; this slowdown is mirrored by a decline in stock-market prices.”  3. “The diffusion of a new GPT generates an increase in wage inequality both between and within educational groups.” How much will global warming cool global growth? Nordhaus was awarded the Nobel prize in 2018 “for integrating climate change into long-run macroeconomic analysis.” created the DICE model (Dynamic Integrated Climate Economy model) Uses a neoclassical growth model in which he integrated a damage function, an abatement function and equations to relate GDP growth to the increase in CO2 levels, and the impact of that increased CO2 on the average global temperature Criticism (Weitzman): society can face indefinable high losses (in Expected Utility) from “high-impact, low-probability catastrophes” (Dismal Theorem). – implication is that we have to take huge actions to avoid a climate catastrophe. There is very high degree of uncertainty regarding future climate change, not accounted for by the cost-benefit-analysis CBA of Nordhaus. optimal policy from the standard CBA is to gradually tighten emissions until they stabilize at levels of CO2-e GHGs that approach 700 ppm. But these are unprecedented levels! Disagreement over whether a permanent change in temperature will affect levels or growth rates of income in the long run. DICE model: warming in each future period affects output only in current period. » Others allow temporary temperature shocks to have lasting effects on income; permanent changes in temperature will affect the long run growth rate of income. These project that countries will experience permanent growth effects from warming and diverge perpetually in their income trajectories, with hot countries growing ever poorer and cold countries experiencing accelerating growth as they warm. evidence that global growth is tied together across countries countries at the frontier of global technology tend to grow at similar rates, with no discernible correlation between domestic growth and domestic innovation or investment rates. country-specific shocks are unlikely to cause permanent changes in country-level growth rates differences in levels of income across countries persist strongly, while growth differences tend to be transitory countries follow a common growth process but can vary dramatically in their levels of income = international spillovers prevent countries from differing permanently in their growth rates as global temperatures change permanent temperature changes could still have persistent effects on growth for years, or even decades, as countries transition toward a new steady-state In hot countries (25C), an unexpected 1C increase in temperature reduces GDP by approximately 1pp in the year of a shock. GDP remains lower for years after the shock  Cold countries show the opposite pattern: an unexpected increase in temperature increases output persistently for several years. Most of the countries that are innovation leaders have average temperatures near the bliss point (13C): warming is less likely to affect the pace of frontier TFP growth. projections suggest that 3.7C of warming could reduce global GDP by 7-12% in 2099 relative to a scenario with no warming Health and Economic Growth Belief that investing in health in LDC’s not only improves welfare (quality and length of life) but also increases development Effects of better health: Direct: Higher productivity Indirect: higher incentives to invest in HC, higher investment in K, higher MPK. Weil (2007) study only direct effects. Eliminating health differences among countries would reduce the variance of log GDP per worker by 9.9%. “Depending on the period being examined, the welfare gain from better health may be as large or larger than the welfare gain from rising consumption.” Two – way causality between health and income “Healthier individuals are more productive, learn more in school, and, because they live longer, face enhanced incentives to accumulate human capital” leading to higher growth. They also face less disability higher income for individuals or countries improves health in a variety of ways, ranging from better nutrition to construction of public health infrastructure, leading to an effect of income on health. other factors simultaneously raise income and improve health outcomes: institutional quality (for countries) and human capital (for individuals), leading to an observed correlation btw health and income Consumption, Saving, and Income Consumption: household spending on final goods and services.It’s spending on just about anything people buy in their personal lives: ○ Food, rend, clothes, medical bills, cars, internet services, rent, electricity, etc. ○ It’s the single largest component of GDP. ○ Consumption is more than half of GDP. Consumption function: a curve plotting the level of consumption associated with each level of income. ○ Visual summary of household spending plans. ○ Shows how consumption varies with income.  ○ Average consumption per person in Australia is higher than any time in our history Average consumption in Australia is higher than in other countries, largely because Australians enjoy a higher average income than nearly any other country Marginal propensity to consume: the fraction of each extra dollar of income that households spend on consumption. ○ The value will fall somewhere between zero and one. The marginal propensity to consume determines the slope of the consumption function. Saving: the portion of income that you don’t spend in a given period. Your consumption decisions determine your savings (and vice versa): Savings = Income − Consumption ○ Putting unspent income in the bank. ○ Using your unspent income to pay down existing debt. ○ When you graduate and start paying your student loans out of your income, you are saving. Savings adds to your wealth, and thus boosts your consumption in the future. (micro view) Savings provides the flow of resources the financial sector uses to fund investment projects (macro view0) Your stock of savings is your wealth. All the money you’ve saved up over time.  Stock versus flow: New saving, consumption and income in a specific period of time are considered flows. Net wealth: the amount by which your assets exceed your debts Dissaving: the excess amount you consume above your income in a given period that you therefore must pay for by either withdrawing money from your savings or borrowing money. Referred to as negative saving ○ Your student loans are a form of dissaving. ○ You borrowed money to fund the gap between your spending as a student and your income. The Micro Foundations of Consumption Interdependence principle: The choices available to you in the future depend on the decisions you make today. Too much spending today creates future repayment challenges. Marginal principle: breaks a “how many” question into a series of smaller marginal choices. Should I spend one more dollar when filling my car with petrol today? Cost-benefit principle: Does the benefit of spending an extra dollar on consumption exceed the cost? If yes, then you should increase your consumption by a dollar Opportunity cost principle: “Or what?” Instead of consuming that extra dollar today, you could save that dollar, earn interest, and then spend that dollar-plus-interest in the future The four core principles at work: Marginal principle: Evaluate whether to spend one more dollar. Cost-benefit principle: Compare the marginal benefit of raising consumption today with the marginal costs… Opportunity cost principle: where the marginal cost accounts for the forgone opportunity to increase consumption in the future by a dollar-plus-interest. Interdependence principle: Think about how your choices to spend today impact your future choices. The rational rule for consumers: Consume more today if the marginal benefit of a dollar of consumption today is greater than (or equal to) the marginal benefit of spending a dollar plus interest in the future. 1. Tells you when to consume. Reminds you to be forward looking. Result: you spend each dollar at the moment in which it yields the largest possible benefit to you. 2. You should keep spending until the marginal benefit is the same over time. Reallocate your spending so that the marginal benefit of the last dollar of consumption is the same in the present as in the future. Leads to the concept of consumption smoothing → let’s explore further! Consumption smoothing: maintaining a steady or smooth path for your consumption spending over time. RECALL diminishing marginal benefit: The marginal benefit of the first few dollars of spending are high, and then decline as you spend more. Increase your total benefits by… ○ reallocating a dollar of consumption from a time of plenty (when you spending is high)… ○ to a time of relative poverty (when your spending is low). Permanent income: your best estimate of your long-term average income. Measures the resources available for you to consume, on average, over the course of your lifetime. EG ○ A couple with a child apply for a home loan. Both are in graduate school, but close to finishing: ○ One about to graduate from law school, ○ the other about to graduate from dental school. The couple currently live off a small stipend provided by their degree programs. While their current income is low, their permanent income is expected to be high, and so the bank approves them for a sizable home loan. Permanent Income Hypothesis the idea that consumption is driven by permanent income rather than current income. Macroeconomic implication: Economic fluctuations matter only to the extent that they affect permanent income. Consumption smoothing requires saving and borrowing! ○ Borrow or save to make up the difference between your current and permanent income: ○ Borrow (or dip into your savings) when your current income is below your permanent income. ○ Save whenever your current income exceeds your permanent income The Macroeconomics of Consumption The relationship between consumption and income 1. A temporary change in income leads to a small change in consumption. Everyday examples: ○ One-time singing bonus from a job. ○ Monetary gift from a relative. ○ One-time government payment 2. A permanent change in income leads to a large change in consumption. ○ Your new job unexpectedly pays $20,000 a year more than your old job 3. An anticipated change in income leads to no change in consumption. Your permanent incomes already reflects your expectations about how your income will evolve over time ○ Example: Put yourself in the shoes of a polling expert expecting to earn $60,000 in every third year (when there is a federal election), but $45,000 in other years (when you have fewer clients). ○ Instead of cutting your consumption spending every second year only to raise it the next, you will be better off spending $50,000 each year. ○ This is in line with your permanent income. 4. Learning about a future income change leads to a change in consumption. Getting the news is what triggers a change in consumption ○ Example: If your company unexpectedly tells employees about company-wide plans for layoffs next month, then you immediately start cutting back on your consumption today. Broader implication: Changes in macroeconomic policy begin to effect consumption from the moment the policy change is announced, rather than when the policy is implemented 5. It’s hard to forecast changes in consumption. Recap: Changes in consumption are driven by reactions to unexpected news. But unanticipated changes are, by their natures, difficult to forecast. Adding behavioral economics and crediting constraints to our analysis There are limitations to how much people can smooth their consumption. Sometimes borrowing and saving isn’t easy or even possible Credit constraints: limits on how much you can borrow. Banks are often reluctant to lend money when the loan isn’t backed by collateral. ○ Collateral: an asset they can take over if you fall behind on your loan repayments. Temptation and impulse purchases; procrastination; unexpected needs; impatient regarding trade-offs between today and tomorrow Hand-to-mouth consumers Hand-to-mouth consumers spend their income as they receive it.  Their marginal propensity to consume is 1. They do not smooth consumption. Their consumption reflects their current income rather than their permanent income. Not a judgement, but a reality: ○ They find it hard to borrow and difficult to save. ○ Spend all their income on necessities. ○ Live paycheque-to-paycheque Modifying insights: The macroeconomy includes both consumption smoothers and hand-to mouth consumers The five insights from earlier describe how consumption smoothers react to income changes. Modify these five insights to account for hand-to-mouth consumers. 1. A temporary change in income leads to a small change in consumption for consumption smoothers and a large change in consumption for hand-to-mouth consumers. 2. A permanent change in income leads to a large change in consumption from both consumption smoothers and hand-to-mouth consumers. 3. An anticipated change in income leads to no change in consumption for consumption smoothers, but a large change for hand-to-mouth consumers. 4. Learning about a future income change leads to a large change in consumption for consumption smoothers, but no change for hand-to–mouth until the extra income arrives. 5. Forecasting changes in consumption depends on the share of hand-to-mouth consumers What Shifts Consumption? Movement along versus shift Shifting the consumption curve Recall: The interdependence principle says that everything is connected The four factors that shift the consumption curve: Real interest rates ○ Effect on savings: Benefit of savings = the interest you’ll earn. High real interest rate → increase in saving. ○ Effect on consumption: TWO FORCES! Substitution effect: spend a dollar today or a dollar + interest in the future?  High real interest rate → reduce current consumption Income effect: a high real interest rate boosts income for lenders → higher consumption. decreases income for borrowers → reduce consumption ○ Most evidence suggests high real interest rates lead to a decrease in consumption. Expectations ○ Optimistic about future economic growth translates into higher consumption. ○ Pessimistic expectations translate into lower consumption. COVID pandemic: Pessimistic expectations lead to “excess savings.” Taxes ○ Disposable income: your after-tax income. ○ A tax cut increases your disposable income. translates into higher consumption ○ Higher taxes decrease your disposable income. translates into lower consumption. ○ Tax cuts as a government tool for stimulus: Effective stimulus with hand-to-mouth consumers. Not effective with consumption smoothers Wealth ○ Greater wealth translates into higher consumption. ○ Lower wealth translates into lower consumption. ○ Factors that influence wealth: Stock markets Housing (double-edged sword) Saving Savings motives: Changing income over the life cycle. Most people borrow when young, save in midlife, and spend down savings in retirement Consumption smoothing suggests: Save money in the phases when income is predictably higher Changing needs over the life cycle Save when you have fewer needs. Spend when there is greater need.  Spend modestly in your early 20s because your needs are likely to rise as you enter your 30s Rational rule for consumers implication: Shift your spending to times in your life when it will yield the largest marginal benefit. Bequests Your may want to build up a stock of wealth to pass on when you die: Inheritance for children Money for a cause you care about Precautionary saving Precautionary saving: saving to be prepared for a financial emergency. Hope for the best but prepare for the worst. Losing your job, health crisis, car repair, etc. Macroeconomic Investment Investment: purchases of new capital, which increase the economy’s productive capacity. Capital: assets such as equipment, structures, and intellectual property that are used to produce output. Macroeconomics investment examples Purchases of new ○ equipment ○ structures ○ research and development for new software Colloquial meaning of investment: ○ a new suit for a job interview ○ your education ○ the stock market ○ These investments do NOT involve purchasing new capital assets like machines. Investment adds to the capital stock; depreciation subtracts from it. Capital stock: the total quantity of capital at a point in time. Investment is the flow of new purchases of capital that add to this stock. Depreciation: the decline in capital due to wear and tear, obsolescence, damage, and aging. Investment type one: Business investment Business investment: the money that businesses spend on new capital assets. ○ Equipment: new computers, machines, tools, company cars, etc. ○ Structures: new offices, stores, factories, remodeling of existing facilities. ○ Intellectual property: software, research and development, spending on literary, television, movie and music production. These three types of business investment all have one thing in common – they are purchases by businesses that increase the productive capacity of the economy. Investment type two: Housing investment Housing investment: the money spent on building or improving houses or apartments. ○ Building a new home counts as macroeconomic investment because it increases the economy’s capacity to generate rent. ○ Opportunity cost principle: your home could be used to generate rental income. ○ Existing homes don’t count as macroeconomic investment because they don’t create any new capital. ○ Simply a transfer of ownership Investment type three: Inventories Businesses also invest by maintaining inventories of raw materials, work-in progress, and unsold goods. ○ Example: The cars for sale at your local car dealership or the furniture in stock at IKEA stores are counted as inventories ○ An increase in inventories is counted as macroeconomic investment.  ○ Tiny share of total investment ○ Volatile Investment and the business cycle Investment fluctuates dramatically as business conditions change: ○ Possible impact of recession: ○ GDP declines 1% ○ Investment declines 10% Investment is sensitive to… ○ Future expectations about the state of the economy. ○ Financial sector conditions (e.g. harder to get loans). Businesses often need to get loans to fund their investments. Countries with more capital per worker produce more output per worker. Key take-aways: What is investment? Tools to Analyse Investments Evaluating investment decisions Key trade-off: up-front costs and future benefits Goal: figure out how to value today’s costs relative to future benefits. ○ Compare values at different points in time. ○ Two analytical tools: compounding and discounting ○ First develop these two tools and then apply them to illustrate how to make investment decisions. opportunity cost: How much would your money grow if you put it in the bank and left it to accumulate over time Compounding: the accumulation of money over time, as you earn interest on both your principal and accrued interest. Diving into the Definition: le: What happens when you put $100 in the bank if the interest rate is 3%? ○ A year later you’ll get $100 back plus $3 in interest: ○ $100 + $3 = $103 What happens if you leave that money in the bank for another year? ○ A year later you’ll get $103 back plus $3.09 in interest: ○ $103 + $3.09 = $106.09 Investment Tool One: Compounding Investment Tool Two: Discounting Discounting: Converting future values into their equivalent present values. Real versus nominal interest rates RECALL: Nominal values refer to the number of dollars you have. ○ To assess the nominal value of your funds, use the nominal interest rate in the compounding or discounting formula. Real values adjust for inflation. ○ To assess the real value of your funds, use the real interest rate in the compounding or discounting formula. ○ This focuses on your purchasing power. ○ Takes into account that goods likely to cost more dollars in the future The Market for Loanable Funds Forecasting the long-run real interest rate Long-run real interest rate evolves slowly over many years in response to supply and demand in the market for loanable funds. Short-run real interest rate rises and falls each month with adjustments from the Reserve Bank of Australia. The market for loanable funds determines the long-run real interest rate, and therefore the quantity of investment Market for loanable funds: The market for the funds used to buy, rent, or build capital. ○ Brings together: ○ Savers who want to lend their funds ○ Investors who want to borrow funds. ○ Supply shifter one: Changes in personal saving rates Personal saving refers to saving by households of whatever income they don’t spend or pay as taxes. ○ Putting money in the bank ○ Paying down your debt ○ Anything that shifts people’s willingness to save will shift the supply of loanable funds. Supply shifter two: Government saving shifts due to changing budget surpluses and deficits  Government saving refers to saving by the government. Budget surplus: when the government spends less than its revenue. - ○ These extra government funds are typically used to repay government debt, which frees up those funds for others to borrow. ○ Increases the supply of loanable funds available (rightward shift). Budget deficit: when the government spends more than its revenue. ○ The government borrows by issuing bonds which people and businesses buy with their savings. ○ Less savings leads to a decrease in the supply of loanable funds. ○ Thus, a government deficit decreases the supply of loanable funds available (leftward shift). Supply shifter three: Global shocks shift foreign saving Foreign savings (or net financial inflows) is the funding that comes from foreigners lending money to Australians. ○ Example: In the early 2000s an increase in saving in the rapidly growing Asian countries and oil-producing Middle East increased global savings. ○ Some of this saving was lent to Australian companies. ○ Rise in foreign saving shifted the supply of loanable funds to the right. ○ Pushed down the equilibrium real interest rate Shifting the demand of loanable funds An increase in investment shifts the demand for loanable funds to the right… ○ higher real interest rate. A decrease in investment shifts the demand for loanable funds to the left… ○ lower real interest rate. Any factor that shifts investment will also shift the demand for loanable funds: ○ Technological advances ○ Changes in expectations ○ Corporate tax cuts ○ Easier lending standards Banks Banks do not simply store your money for you. Banks take your money and put it to work by lending it out. ○ Car loans; home loans; funding for companies like Nike How do banks make money? by charging higher interest rates than they pay. Banks as borrowers: pays you interest on your deposit. Banks as lenders: lends your deposit out to someone else at a higher interest rate.  Example: bank pays 2% interest on deposits and receives 6% interest on loans, which means the bank gets 4%! What do banks do Pool savings from many savers ○ Function 1: Banks pool savings from many savers. Easier for borrowers to go to one bank than to try and borrow from many individuals. Spread the risk of lending money across many borrowers ○ Function 2: Spread the risk of lending ○ The bank does not lend all your savings to one borrower. ○ Rather, lends to a diverse array of borrowers. ○ More diverse portfolio = less risky loans Solve information problems ○ Function 3: Solve information problems ○ Only lends to borrowers after investigating their financial history. ○ Identify which borrowers can repay their loans. Provide payment services ○ Function 4: Provide payment services ○ A bank’s payment services are often more convenient than using cash. ○ Pay deposited directly into your bank account; pay bills online; send money overseas via bank transfer; shop online using credit card. Create long-term loans from short-term deposits ○ Function 5: Long-term loans from short-term deposits ○ Maturity transformation: using short-term loans to make long-term loans. ○ This can cause problems and creates risk. ○ Savers expect they can withdraw their fund whenever they want, but borrowers repay over a longer period of time. Bank run Bank run: when many bank customers try to withdraw their savings at the same time. can cause a bank to collapse. Interference principle: Your best choice depends on what others will do, and vice versa. Deposit insurance makes bank runs much less likely ○ Covers up to $250,000 per account. ○ Breaks the interdependence that leads to self-fulfilling panics. ○ No reason to panic as your money is guaranteed by the government Shadow banks Financial firms that act like banks but, since they are not actually banks, do not have to follow the same rules as banks ○ Take funds from investors and use these funds to make longer-term investments.  ○ Engaged in activities that involve greater risk (but higher potential returns) Shadow banks are opaque ○ Unknown interdependencies can make small problems balloon into big ones. ○ Like knowing a small share of the meat supply is infected but not knowing which shipments are affected ○ millions of people stop eating meat. ○ If you don’t know which shadow banks are infected with bad loans (and there’s no deposit insurance), then you won’t lend to any of them. ○ A relatively small number of bad loans in 2008 brought a sharp decline in lending, which sparked a major recession The Bond Market Bond: an IOU. Specifically, a promise to pay back a loan with interest. The bond market is where the big firms go to borrow the big bucks The bond records Issuer: the borrower ○ If Nike issued a bond to fund their $1 billion investment, then Nike is the issuer. Principle: the amount to be repaid ○ For Nike, $1 billion. Maturity date: due date for repayment ○ For Nike, November 1, 2026. Coupons: interest paid along the way ○ Nike pays 2.375% interest per year. What does the bond market does Channel funds from savers to borrowers ○ Function one: The bond market channels funds from savers to borrowers. ○ Provides an alternative to banks where companies can borrow large sums. Funds government debt ○ The bond market funds government debt. ○ For example, the U.S. government borrows money by issuing bonds. It has borrowed over $15 trillion by issuing bonds. ○ The U.S. federal government is the biggest player in the bond market. Spreads risk ○ The bond market spreads risk.  ○ Nike issues thousands of bonds, rather than issuing one $1 billion bond to one person. Creates liquidity ○ The bond market creates liquidity. ○ There are many buyers in the bond market so you can always resell the bond you bought from Nike if you suddenly discover you need the cash before the maturity date. ○ Liquidity: the ability to quickly and easily convert your investments into cash, with little or no loss in value. The bond market: Evaluating risks Default risk is the risk of not getting paid. ○ Domestic companies like Australia Ratings and U.S. companies like Fitch, Standard and Poor’s and Moody’s evaluate companies and assign credit ratings. ○ Use these credit ratings to assess default risk. ○ AAA is the highest possible ratings Term risk arises when there’s uncertainty about future interest rates (i.e. interest rate risk) ○ Tying up your money comes with an opportunity cost ○ The longer the term of the loan, the more interest rates might change, and so the higher the term risk: ○ Example: You buy a bond which pays out 2.375% per year for 20 years. If interest rates shoot up to 4%, then you’re missing out on the opportunity to earn a bigger return because your money is tied up in the bond. Liquidity risk arises when there is a risk that your bond will be hard to sell. ○ There’s a risk that you won’t be able to quickly find a buyer for your bonds during the time when you need those funds yourself U.S. government bonds Treasuries: bonds issued by the U.S. government. U.S. government bonds are the safest investment. ○ The U.S. government can always repay its debt by simply printing more money ○ Of course, this is likely to lead to higher inflation but it’s possible in theory U.S. government bonds are the most heavily traded bonds in the world. ○ $500 billion traded each day. ○ Carry basically no liquidity risk or default risk ○ But low risk comes with lower reward (very low interest rate on Treasuries) The Stock Market  A company can also finance expansions or investment projects by raising money with the sale of stock to the public. Stock: partial ownership in a firm. ○ Stock is sometimes called a share. ○ Owners of stock are called shareholders. A stock entitles you to a share of future profits Dividends: A share of profits that a company pays to its shareholders ○ Over the course of the year, the dividend payments usually add up to a return equal to about 1% or 2% the value of the stock. ○ Dividend payments can depend on whether the company is in growth phase or not. The value of your shares can rise. ○ A company’s growing future profitability = higher value company = higher stock price ○ The stock you own is now worth more! ○ Essentially you believe that the company will pay higher dividends in future What stocks do: Stocks channel funds from savers to investors. ○ Companies primarily issue stock to raise money to fund investments in their growth as a company ○ Initial public offering (IPO): when a company first sells stock directly to the public. ○ Issuing stock is an alternative to borrowing (either from bank or through issuing bonds) Function two: Stocks spread risk ○ Shareholders gain when the company gains but do badly when the company does badly. ○ Stocks spread the risk of business performance across many shareholders, reducing the risk any one person faces. ○ Shareholders can spread risk across companies : Stocks reallocate control. ○ As a shareholder, you get a say in how the company is run. ○ Shareholders vote in shareholders meetings: ○ Elect the board of directors. ○ Vote on major issues (mergers, senior management wages). ○ Get to ask questions at annual meetings. The stock market creates liquidity The stock market is a market for second-hand stock. ○ stock market: the market people buy and sell existing stocks. Funds used to buy stock in the stock market do NOT go to the company. ○ You’re buying from an existing shareholder.  ○ Nike gets nothing when you buy a pre-owned stock. Main role of stock market ○ creates liquidity that encourages people to invest in companies. ○ Investors know that if you buy shares you will be able to sell them easily International Trade and Global Financial Flows Definitions International trade occurs when people buy or sell goods and services across national borders Exports: goods or services produced domestically and purchased by foreign buyers Imports: goods or services produced in a foreign country and purchased by domestic buyers. Globalization describes the increasing global integration of economies, cultures, political institutions, and ideas. ○ Cheaper air transport ○ Larger cargo ships (carries 100× more cargo than 50 years ago) ○ Computer networks allows for fast and easy exchange of data. Australian imports and exports have grown rapidly Major Australian exports: ○ Natural resources (iron ore and coal), agricultural products (beef and wine), and around one-fifth of our exports are services. Major Australian imports: ○ Clothes, household appliances, or cars may be what first come to mind, but… ○ Some of our largest imports are intermediate goods or raw materials. Example: Import crude oil, and then Australian businesses refine it and ship it out as exports of refined petroleum Investment dollars are also being traded internationally Financial inflows: investments by foreigners in Australia. Financial outflows: investments by Australians in foreign countries. Financial investment flows take three main forms: 1. Foreign direct investment (investment in physical assets) a. When Hitachi purchased a Sydney-based advanced engineering manufacturer. b. Hires Australian workers, but its profits will return to its Japanese owners 2. Portfolio investment a. When foreigners buy Australian stocks or bonds b. Australian businesses use these funds to invest in new equipment. 3. Deposits and loans a. Loans made directly to Australians, as well as foreign deposits in Australian banks Financial flows have risen sharply 1.Removal of capital controls and deregulation of the financial sector ○ Capital controls were rules designed to limit the flow of money across borders. 2. Large institutional investors (e.g. pension funds and superannuation funds) have become larger and more important over time. ○ Seeking to diversify ○ their portfolios 3. Technology has made investors more comfortable sending their money overseas. 4. Financial innovation — new ways for investors to diversity and hedge their risks in foreign markets (e.g. can hedge currency risk). Exchange Rates Nominal exchange rate: the price of a country’s currency, in terms of another country’s currency. Supply and Demand of Currencies Foreign exchange market: the market in which currencies are bought and sold. ○ The forces of supply and demand determine the equilibrium price and quantity. ○ The price of an Australian dollar is the nominal exchange rate. ○ The number of yen you must pay to buy one Australian dollar. Demanders: those looking to buy Australian dollars in order to purchase Australian products. ○ If a Japanese butcher wants to buy Australian Wagyu beef, the butcher buys Australian dollars in order to purchase the Australian beef. Suppliers: people looking to sell their Australian dollars in return for Japanese yen. ○ An Australian camera shop that imports Nikon cameras will supply Australian dollars in exchange for yen so that it can pay its Japanese wholesaler. The demand for Australian dollars Trade flows: foreigners buying Australian exports. ○ If a Japanese consumer wants to buy Australian products, they need to pay with Australian dollars. ○ Creates demand in the foreign exchange market for Australian dollars! Financial inflows: foreigners investing in Australia. ○ If Japanese investors want to buy Australian assets, they need Australian dollars. ○ Every dollar of financial inflows creates a demand for one Australian dollar! The supply of Australian dollars Trade flows: Australians buying imports ○ If an Australian consumer wants to buy Japanese products, they need to pay with Japanese yen. ○ Australians will supply Australian dollars to obtain the yen needed for the transaction. Financial outflows: Australian investors investing abroad ○ If an Australian investors want to buy Japanese assets, they need Japanese yen.  ○ Every dollar of financial outflows creates a supply of one Australian dollar! Demand shifter 1: Exports from Australia ↑ world GDP ○ A stronger Japanese economy increases the income of Japanese consumers, and some of that extra income will be spent on Australian goods and services. ↓ barriers to foreign markets ○ If Japanese officials eliminated tariffs on Australian beef, this would lead to more Australian exports of beef to Japan. ↑ domestic innovation and marketing ○ Successful innovation and marketing of Australian goods and services to foreign customers will increase Australian exports. ↑ foreign prices ○ If price of beef from New Zealand rises, some Japanese shoppers will switch to Australian beef. ↓ domestic prices ○ If Australian sellers cut their prices, this leads to more exports. Demand shifter 2: Financial inflows into Australia ↑ Australian interest rates relative to foreign interest rates. ○ Foreign investors are sensitive to the opportunity cost principle — looking at the difference between Australian and foreign interest rates. ↑ Australian business profitability relative to foreign businesses ○ Any change that creates more profitable business climate in Australia will lead to more financial inflows. ↑ Foreign political risk relative to Australian political risk ○ Risk of a foreign government coup or seizure of assets further strengthens the Australian reputation as a “safe haven”. ↑ Expected future value of the dollar ○ Any news that might cause the dollar to rise in the future causes speculators to buy dollars now in anticipation of those dollars later rising in value. Supply shifter 1: Imports into Australia ↑ Australian GDP ○ A stronger Australian economy increases the income of Australian consumers, and some of that extra income will be spent on foreign goods and services ↓ barriers prot