Chapter 9 Economic Growth the Financial System and

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Chapter 9: Economic Growth, the Financial System, and Business Cycles CHAPTER 9 Economic Growth, the Financial System, and Business Cycles Prepared by: Fernando Quijano Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. 1 of 33

Chapter 9: Economic Growth, the Financial System, and Business Cycles Economic Growth, the Financial System, and Business Cycles Business cycle Alternating periods of economic expansion and economic recession. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. 2 of 33

9. 1 LEARNING OBJECTIVE Long-Run Economic Growth Discuss the importance of long-run economic growth. Long-run economic growth The process by which rising productivity increases the average standard of living. Chapter 9: Economic Growth, the Financial System, and Business Cycles Figure 9 -1 The Growth in Real GDP per Capita, 1900– 2008 Measured in 2005 dollars, real GDP per capital in the United States grew from about $5, 600 in 1900 to about $43, 700 in 2008. The average American in the year 2008 could buy nearly eight times as many goods and services as the average American in the year 1900. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. 3 of 33

9. 1 LEARNING OBJECTIVE Long-Run Economic Growth Discuss the importance of long-run economic growth. Chapter 9: Economic Growth, the Financial System, and Business Cycles Calculating Growth Rates and the Rule of 70 What Determines the Rate of Long-Run Growth? Labor productivity The quantity of goods and services that can be produced by one worker in one hour of work. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. 4 of 33

9. 1 LEARNING OBJECTIVE Long-Run Economic Growth Discuss the importance of long-run economic growth. What Determines the Rate of Long-Run Growth? Chapter 9: Economic Growth, the Financial System, and Business Cycles Increases in Capital per Worker Capital (K) Manufactured goods that are used to produce other goods and services. Technological Change Economic growth depends more on technological change than on increases in capital per worker. Technological change is an increase in the quantity of output firms can produce using a given quantity of inputs. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. 5 of 33

9. 1 LEARNING OBJECTIVE Solved Problem 9 -1 Discuss the importance of long-run economic growth. Chapter 9: Economic Growth, the Financial System, and Business Cycles The Role of Technological Change in Growth Between 1960 and 1995, real GDP per capita in Singapore grew at an average annual rate of 6. 2 percent. This very rapid growth rate results in the level of real GDP per capita doubling about every 11. 3 years. In 1995, Alywn Young of the University of Chicago published an article in which he argued that Singapore’s growth depended more on increases in capital per worker, increases in the labor force participation rate, and the transfer of workers from agricultural to nonagricultural jobs than on technological change. If Young’s analysis was correct, predict what was likely to happen to Singapore’s growth rate in the years after 1995. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. 6 of 33

9. 1 LEARNING OBJECTIVE Long-Run Economic Growth Discuss the importance of long-run economic growth. Potential GDP Chapter 9: Economic Growth, the Financial System, and Business Cycles Actual and potential GDP Potential GDP increases every year as the labor force and the capital stock grow and technological change occurs. The red line on the next slide represents potential GDP, and the blue line represents actual real GDP. During the three recessions since 1989, actual real GDP has been less than potential GDP. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. 7 of 33

Chapter 9: Economic Growth, the Financial System, and Business Cycles Long-Run Economic Growth Figure 10. 2 © 2015 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. Copyright © 2010 Pearson 8 of 44 8 of 33

Chapter 9: Economic Growth, the Financial System, and Business Cycles Saving, Investment, and the Financial System 9. 2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth. Financial system The system of financial markets and financial intermediaries through which firms acquire funds from households. An Overview of the Financial System Financial markets Markets where financial securities, such as stocks and bonds, are bought and sold. Financial intermediaries Firms, such as banks, mutual funds, pension funds, and insurance companies, that borrow funds from savers and lend them to borrowers. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. 9 of 33

Saving, Investment, and the Financial System 9. 2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth. The Macroeconomics of Saving and Investment Chapter 9: Economic Growth, the Financial System, and Business Cycles Y = C + I + G + NX Y=C+I+G I=Y−C−G = Y + TR − C − T = T − G − TR Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. 10 of 33

9. 2 LEARNING OBJECTIVE Saving, Investment, and the Financial System Discuss the role of the financial system in facilitating long-run economic growth. The Macroeconomics of Saving and Investment Chapter 9: Economic Growth, the Financial System, and Business Cycles S= + or S = (Y + TR − C − T) + (T − G − TR) or S=Y−C−G So, we can conclude that total saving must equal total investment: S=I Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. 11 of 33

Saving, Investment, and the Financial System 9. 2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth. Chapter 9: Economic Growth, the Financial System, and Business Cycles The Market for Loanable Funds Market for loanable funds The interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged. Supply of Loanable Funds the “Saving” curve Demand for Loanable Funds the “Investment” curve Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. 12 of 33

Saving, Investment, and the Financial System 9. 2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth. The Market for Loanable Funds Explaining Movements in Saving, Investment, and Interest Rates Chapter 9: Economic Growth, the Financial System, and Business Cycles FIGURE 9 -4 An Increase in the Demand for Loanable Funds An increase in the demand for loanable funds increases the equilibrium interest rate from i 1 to i 2, and it increases the equilibrium quantity of loanable funds from L 1 to L 2. As a result, saving and investment both increase. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. 14 of 33

Saving, Investment, and the Financial System 9. 2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth. The Market for Loanable Funds Chapter 9: Economic Growth, the Financial System, and Business Cycles Explaining Movements in Saving, Investment, and Interest Rates Crowding out A decline in private expenditures as a result of an increase in government purchases. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. 15 of 33

Saving, Investment, and the Financial System 9. 2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth. The Market for Loanable Funds Explaining Movements in Saving, Investment, and Interest Rates Chapter 9: Economic Growth, the Financial System, and Business Cycles FIGURE 9 -5 The Effect of a Budget Deficit on the Market for Loanable Funds When the government begins running a budget deficit, the supply of loanable funds shifts to the left. The equilibrium interest rate increases from i 1 to i 2, and the equilibrium quantity of loanable funds falls from L 1 to L 2. As a result, S and I both decline. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. 16 of 33

9. 3 LEARNING OBJECTIVE The Business Cycle Explain what happens during the business cycle. Chapter 9: Economic Growth, the Financial System, and Business Cycles Some Basic Business Cycle Definitions FIGURE 9 -6 The business cycle: movements in real GDP (Y) from 2006 -2013. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. 17 of 33

9. 3 LEARNING OBJECTIVE The Business Cycle Explain what happens during the business cycle. How Do We Know When the Economy Is in a Recession? Table 9 -1 Chapter 9: Economic Growth, the Financial System, and Business Cycles The U. S Business Cycle Peak Trough LENGTH OF RECESSION July 1953 May 1954 10 months August 1957 April 1958 8 months April 1960 February 1961 10 months December 1969 November 1970 11 months November 1973 March 1975 16 months January 1980 July 1980 6 months July 1981 November 1982 16 months July 1990 March 1991 8 months March 2001 November 2001 June 2009 8 months 18 months December 2007 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. 18 of 33

The Business Cycle How Do We Know When the Economy Is in a Recession? Chapter 9: Economic Growth, the Financial System, and Business Cycles This is what the media tells you: “A recession is two consecutive quarters of declining real GDP. ” This is what an economist believes: “A recession is a significant decline in general activity spread across the economy and lasting more than a few months. The decline is visible in production, employment, real income, and wholesale-retail trade. ” Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. 19 of 33

The Business Cycle Chapter 9: Economic Growth, the Financial System, and Business Cycles Whirlpool makes household appliances—durable goods. So we expect their sales to be strongly affected by recessions. The charts show that the entire household appliance industry was particularly hard-hit by the recession of 2007 -2009. The effect of the business cycle on Whirlpool. Panel a shows movements in real GDP; panel b shows movements in the real value of manufacturers’ sales of household appliances. © 2015 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. Copyright © 2010 Pearson 20 of 44 20 of 33

The Business Cycle What Happens during the Business Cycle? Chapter 9: Economic Growth, the Financial System, and Business Cycles The Effect of the Business Cycle on the Inflation Rate Notice that inflation tends to rise toward the end of an expansion and fall over the course of each recession. Toward the end of a typical expansion, the inflation rate begins to rise. Recessions, marked by the shaded vertical bars, cause the inflation rate to fall. By the end of a recession, the inflation rate is significantly below what it had been at the beginning of the recession. © 2015 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. Copyright © 2010 Pearson 21 of 44 21 of 33

The Business Cycle What Happens during the Business Cycle? Chapter 9: Economic Growth, the Financial System, and Business Cycles The Effect of the Business Cycle on the Unemployment Rate As firms see their sales start to fall in a recession, they generally reduce production and lay off workers. Notice that unemployment often continues to rise after the end of each recession. Unemployment rises during recessions and falls during expansions. The reluctance of firms to hire new employees during the early stages of a recovery means that the unemployment rate usually continues to rise even after the recession has ended. © 2015 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. Copyright © 2010 Pearson 22 of 44 22 of 33

9. 3 LEARNING OBJECTIVE The Business Cycle Explain what happens during the business cycle. What Happens during the Business Cycle? Is the “Great Moderation” Over? Chapter 9: Economic Growth, the Financial System, and Business Cycles FIGURE 9 -10 Fluctuations in Real GDP, 1900– 2008 Fluctuations in real GDP were greater before 1950 than they have been since 1950. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. 23 of 33

9. 3 LEARNING OBJECTIVE The Business Cycle Explain what happens during the business cycle. What Happens during the Business Cycle? Is the “Great Moderation” Over? Chapter 9: Economic Growth, the Financial System, and Business Cycles Table 9 -2 Until 2007, the Business Cycle Had Become Milder PERIOD AVERAGE LENGTH OF EXPANSIONS OF RECESSIONS 1870 -1900 26 months 1900 -1950 25 months 1950 -2009 61 months 11 months Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. 24 of 33

9. 3 LEARNING OBJECTIVE The Business Cycle Explain what happens during the business cycle. Will the U. S. Economy Return to Stability? Chapter 9: Economic Growth, the Financial System, and Business Cycles Economists have offered several explanations of why the U. S. economy experienced a period of relative stability from 1950 to 2007: • The increasing importance of services and the declining importance of goods. • The creation of unemployment insurance and other government transfer programs that provide funds to the unemployed. (These are called “automatic stabilizers. ”) • Active federal government policies to stabilize the economy. (Via monetary policy and fiscal policy. ) • The increased stability of the financial system. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. 25 of 33

KEY TERMS Business cycle Chapter 9: Economic Growth, the Financial System, and Business Cycles Capital (K) Crowding out Financial intermediaries Financial markets Financial system Labor productivity Long-run economic growth Market for loanable funds Potential GDP Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3 e. 26 of 33