Week 7 - Chapters 10 & 11 - Jacksonville University Econ 201 Fall 2024

Ch. 10 and 11 Long Run Economic Growth Jacksonville University Econ 201 Week 7 (Fall 2024) Outline Long-Run Economic Growth (The Per-Worker Production Function) Saving, Investment, and the Financial System The Business Cycle The Catch-up Theory Readi...

Ch. 10 and 11 Long Run Economic Growth Jacksonville University Econ 201 Week 7 (Fall 2024) Outline Long-Run Economic Growth (The Per-Worker Production Function) Saving, Investment, and the Financial System The Business Cycle The Catch-up Theory Reading Assignment: Hubbard & O’Brien – Chapter 10 & Chapter 11 (Sections 11.2 and 11.4) Long-Run Economic Growth o When we speak of long-run economic growth, we mean the process by which rising productivity increases the average standard of living. o The most commonly used measure of this average standard of living is real GDP per capita: the amount of production in the economy, per person, adjusted for changes in the price level. o Real GDP per capita has risen more than eight-fold since 1900; the average American can buy more than nice times as many goods and services now as in 1900. Calculating Growth Rates The growth rate of an economic variable like real GDP or real GDP per capita is equal to the percentage change from one year to the next. In 2021, Real GDP was $21.4 trillion In 2022, Real GDP was $21.8 trillion  $21.8 trillion  $21.4 trillion    100 1.9%  $21.4 trillion  Growth Rates over a Few Years Over periods of a few years, we can average the growth rates to find the approximate annual rate of growth. In 2020, real GDP growth was -2.2% In 2021, real GDP growth was 5.8% In 2022, real GDP growth was 1.9% So, the average annual growth rate over this three-year period was:  2.2%  5.8%  1.9% 1.8% 3 Growth Rates Over Longer Periods – Rule of 70 o A useful formula called the Rule of 70 can help us to determine how long it will take for an economic variable to double: 70 Number of years to double  Growth rate o If growth rate is 5 percent, the variable will double in 70/5 = 14 Years What Determines the Rate of Long-Run Growth? Increases in real GDP per capita rely on increases in labor productivity: the quantity of goods and services that can be produced by one worker or by one hour of work. So, most of the answer to “what determines the rate of long-run growth” is the same as the answer to “what determines labor productivity growth?” 1. Increases in capital per hour worked Capital is manufactured goods that are used to produce other goods and services. The more capital a worker has available to use (including human capital, the accumulated knowledge and skills workers possess), the more productive he or she will be. 2. Technological change Improvements in capital or methods to combine inputs into outputs (i.e. new technologies) allow workers to produce more in a given period of time. The role of entrepreneurs here is critical, in pioneering new ways to bring together the factors of production to produce better or lower cost products. *Other factors include, private property rights, independent court system, financial system, education system. The Per-Worker Production Function Two main factors affect labor productivity: The quantity of capital per hour worked and The level of technology. Suppose we wanted to describe a per-worker production function: the relationship between real GDP per hour worked and capital per hour worked, holding the level of technology constant. The first units of capital would be the most effective, allowing output per hour to increase most. Subsequent increases would result in diminishing returns: smaller incremental increases in output. Technological Change Increases Output Per Hour Worked If a country is relatively lacking in capital—like many of the developing countries—increases in capital will be very effective at increasing real GDP per capita. In countries where the amount of capital is already relatively high, technological change becomes a more effective way to increase output per hour. Potential GDP Potential GDP refers to the level of real GDP attained when all firms are operating at capacity. Capacity here refers to “normal” hours and a “normal” sized workforce. Potential GDP rises when the labor force expands, when a nation acquires more capital stock, or when new technologies are created. The growth in potential GDP in the U.S. has been relatively steady at about 3.3 percent; that is, the potential to produce final goods and services has been growing in the U.S. at about this rate over time. The recession of 2007-2009 resulted in a wider than usual gap between potential and actual GDP, as the next slide illustrates. Actual and Potential GDP Financial Markets and Financial Intermediaries Financial markets are markets where financial securities, such as stocks and bonds, are bought and sold. Financial security: a document (sometimes electronic) stating the terms under which funds pass from the buyer of the security to the seller. Stock: a financial security representing partial ownership of a firm. Bond: a financial security promising to repay a fixed amount of funds. A bond is essentially a loan from a household to a firm. Financial intermediaries are firms, such as banks, mutual funds, pension funds, and insurance companies, that borrow funds from savers and lend them to borrowers. The Market for Loanable Funds The financial system is composed of many different markets—the market for stocks, for bonds, for certificates of deposits at banks, etc. A convenient way to model these is as a single market: the market for loanable funds, a (conceptual) interaction of borrowers and lenders determining the market interest rate and the quantity of loanable funds exchanged. For now, we will assume that interactions are only between domestic households and firms—there is no interaction with foreign lenders and borrowers The Market for Loanable Funds Firms borrow loanable funds from households. They borrow more when households demand a lower return on their money—a lower real interest rate. Households supply loanable funds to firms. They provide more when firms offer them a greater reward for delaying consumption—a higher real interest rate. Governments, through their saving or dissaving, affect the quantity of funds that “pass through” to firms. An Increase in the Demand for Loanable Funds Suppose that technological change occurs so that investments become more profitable for firms. This will increase the demand for loanable funds. The real interest rate will rise, as will the quantity of funds loaned. Summary of Loanable Funds Model (Demand Curve Shifts) Graph of the effect on equilibrium in the loanable funds An increase in … will shift the … causing … market expected future demand for the real interest rate profits loanable funds and the level of curve to the right investment to increase. corporate taxes demand for the real interest rate loanable funds and the level of curve to the left investment to decrease. Summary of Loanable Funds Model (Supply Curve Shifts) Graph of the effect on equilibrium in the loanable funds An increase in … will shift the … causing … market the government’s supply of loanable the real interest budget deficit funds curve to the rate to increase and left investment to decrease. the desire of supply of loanable the real interest households to funds curve to the rate to increase and consume today left investment to decrease. tax benefits for supply of loanable the real interest rate saving, such as funds curve to the to decrease and 401(k) retirement right investment to accounts, which increase. increase the incentive to save The Effect of a Budget Deficit on the Market for Loanable Funds Suppose the government runs a budget deficit. To fund the deficit, it sells bonds to households, decreasing the supply of funds available to firms. This raises the equilibrium real interest rate and decreases the funds loaned to firms. This is crowding out: the decline in private investments as a result of increases in government purchases. In practice, the effect of government budget deficits and surpluses on the equilibrium interest rate is relatively small. Interest rates are influenced by global markets, so even a few hundred billion dollars is a relatively minor amount. The Business Cycle While real GDP per capita has risen about eight-fold since the start of the twentieth century, it has not risen consistently every year. Since at least the early nineteenth century, the American economy has experienced alternating periods of expanding and contracting economic activity. These alternating periods are called the business cycle. The Business Cycle The figure shows a typical idealized path for real GDP— rising, falling, then rising again. The phases of rising are known as expansion; the periods of falling are recessions. We refer to the points at which the economy changes from one phase to the other as peaks or troughs, respectively. The Business Cycle This figure shows the movements in real GDP in the U.S. from 2006 to 2015. The period of recession starting in late 2007 and ending in mid 2009 was the longest and most severe since the Great Depression of the 1930s, prompting some to refer to it as the Great Recession. Real GDP growth after this recession has been slower than is typical at the start of a business cycle expansion. Effects of Business Cycles on Firms When a recession hits, workers reduce spending due to expectations about their current and future incomes decreasing. But this reduction in spending doesn’t affect all goods equally. Consumers mostly continue to buy nondurables like food and clothing. But purchases of durable goods, ones that (by definition) are expected to last three or more years, are more strongly affected. This includes goods like furniture, appliances, and automobiles—goods that consumers can continue to use for a little longer when their purchasing power decreases. Hence firms selling durable goods are more likely to be hit hard by a recession. The Effect of the Business Cycle on Inflation The inflation rate measures the change in the price level from one year to the next. During expansions, demand for products is high relative to supply, resulting in prices increasing—high inflation. During recessions, demand for products is low relative to supply, resulting in prices increasing more slowly or even decreasing—low inflation or deflation. The graph on the next slide shows the movements in the (CPI) inflation rate over the last two decades. The Effect of Recessions on the Inflation Rate How Recessions Affect the Unemployment Rate Why Isn’t the Whole World Rich? The economic growth model predicts that poor countries will grow faster than rich countries. This is because: The effect of additional capital is greater for countries with smaller capital stocks There are greater advances in technology immediately available to poorer countries The Catch-Up Predicted by the Economic Growth Model If poorer countries grow faster than richer ones, they will start to catch up to, or converge to, the richer countries. Catch-up: the prediction that the level of GDP per capita (or income per capita) in poor countries will grow faster than in rich countries. There Has Been Catch-Up Among High- Income Countries Examining high-income countries, we appear to see strong evidence of the catch-up hypothesis. Countries that were richer in 1960, like the U.S. and Switzerland, experienced lower growth rates over the next decades than countries that were initially poorer, like Ireland, Singapore, and South Korea. Most of the World Hasn’t Been Catching Up, Why?  The Lack of Growth in Many Low-Income Countries Economists point to four key factors in explaining why many low-income countries are growing so slowly: Failure to enforce the rule of law Wars and revolutions Poor public education and health Low rates of saving and investment