1 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter.

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

2 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 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.

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

4 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Long-Run Economic Growth 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. 9.1 LEARNING OBJECTIVE Discuss the importance of long-run economic growth.

5 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Long-Run Economic Growth What Determines the Rate of Long-Run Growth? Capital (K) Manufactured goods that are used to produce other goods and services. Increases in Capital per Worker 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. 9.1 LEARNING OBJECTIVE Discuss the importance of long-run economic growth.

6 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Solved Problem 9-1 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 LEARNING OBJECTIVE Discuss the importance of long-run economic growth.

7 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Long-Run Economic Growth Potential GDP 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. 9.1 LEARNING OBJECTIVE Discuss the importance of long-run economic growth.

8 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles 8 of 44 © 2015 Pearson Education, Inc. Long-Run Economic Growth Figure 10.2

9 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Saving, Investment, and the Financial System 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. Financial system The system of financial markets and financial intermediaries through which firms acquire funds from households. Discuss the role of the financial system in facilitating long-run economic growth. 9.2 LEARNING OBJECTIVE

10 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Saving, Investment, and the Financial System The Macroeconomics of Saving and Investment Y = C + I + G + NX Y = C + I + G I = Y − C − G = Y + TR − C − T = T − G − TR 9.2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth.

11 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles S = (Y + TR − C − T) + (T − G − TR) S = Y − C − G S = I S = + or So, we can conclude that total saving must equal total investment: Saving, Investment, and the Financial System The Macroeconomics of Saving and Investment 9.2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth.

12 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Saving, Investment, and the Financial System 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 9.2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth.

13 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Demand and Supply in the Loanable Funds Market FIGURE 9-3 The Market for Loanable Funds Saving, Investment, and the Financial System The Market for Loanable Funds 9.2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth.

14 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Explaining Movements in Saving, Investment, and Interest Rates FIGURE 9-4 An Increase in the Demand for Loanable Funds Saving, Investment, and the Financial System 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. 9.2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth. The Market for Loanable Funds

15 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Crowding out A decline in private expenditures as a result of an increase in government purchases. Saving, Investment, and the Financial System The Market for Loanable Funds 9.2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth. Explaining Movements in Saving, Investment, and Interest Rates

16 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 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 Saving, Investment, and the Financial System 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. 9.2 LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth. Explaining Movements in Saving, Investment, and Interest Rates

17 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles The Business Cycle FIGURE 9-6 Some Basic Business Cycle Definitions 9.3 LEARNING OBJECTIVE Explain what happens during the business cycle. The business cycle: movements in real GDP (Y) from

18 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles PeakTrough LENGTH OF RECESSION July 1953May months August 1957April months April 1960February months December 1969November months November 1973March months January 1980July months July 1981November months July 1990March months March 2001November months December 2007 June months How Do We Know When the Economy Is in a Recession? 9.3 LEARNING OBJECTIVE Explain what happens during the business cycle. The Business Cycle Table 9-1 The U.S Business Cycle

19 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles The Business Cycle How Do We Know When the Economy Is in a Recession? 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.”

20 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles 20 of 44 © 2015 Pearson Education, Inc. The Business Cycle 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 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.

21 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles 21 of 44 © 2015 Pearson Education, Inc. The Business Cycle 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. What Happens during the Business Cycle? The Effect of the Business Cycle on the Inflation Rate

22 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles 22 of 44 © 2015 Pearson Education, Inc. The Business Cycle 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. What Happens during the Business Cycle? The Effect of the Business Cycle on the Unemployment Rate

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

24 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles Table 9-2 Until 2007, the Business Cycle Had Become Milder The Business Cycle PERIOD AVERAGE LENGTH OF EXPANSIONS AVERAGE LENGTH OF RECESSIONS months months19 months months11 months What Happens during the Business Cycle? 9.3 LEARNING OBJECTIVE Explain what happens during the business cycle. Is the “Great Moderation” Over?

25 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 9 :Economic Growth, the Financial System, and Business Cycles 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 Business Cycle Will the U.S. Economy Return to Stability? 9.3 LEARNING OBJECTIVE Explain what happens during the business cycle. The increased stability of the financial system. Economists have offered several explanations of why the U.S. economy experienced a period of relative stability from 1950 to 2007:

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