1. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 1 of 34 What we learned in last class: Minimum wage laws Calculate unemployment brought about by Minimum wage laws. Efficiency wage Measuring inflation: Price level: CPI vs. GDP deflator Adjust nominal variables to real variables using CPI Real wage vs. nominal wage Shortcomings of CPI Nominal interest rate vs. Real interest rate Costs of inflation on the economy

2. © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 33 Growth and the Business Cycle at Boeing 9.1Discuss the importance of long- run economic growth. 9.2Discuss the role of the financial system in facilitating long-run economic growth. 9.3Explain what happens during a business cycle. Learning Objectives

3. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 34 Economic Growth, the Financial System, and Business Cycles A key measure of the success of any economy is its ability to increase production of goods and services faster than the growth in population. The only way that the living standard of the average person can increase. The best measure: Real GDP per capita. Economic growth (long-run) Business cycle (short-run) Alternating periods of economic expansion and economic recession.

4. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 34 Long-Run Economic Growth Learning Objective 9.1 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, 1900–2006

5. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 34 Learning Objective 9.1 The Connection between Economic Prosperity and Health Making the Connection

6. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 34 Learning Objective 9.1 The Connection between Economic Prosperity and Health Making the Connection

7. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 34 Long-Run Economic Growth Learning Objective 9.1 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 or by one hour of work.

8. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 34 Long-Run Economic Growth Learning Objective 9.1 What Determines the Rate of Long-Run Growth? Capital Manufactured goods that are used to produce other goods and services. Human capital: Accumulated knowledge and skills workers acquire from education and training or their life experiences Increases in Capital per Hour Worked

9. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 34 Long-Run Economic Growth Learning Objective 9.1 What Determines the Rate of Long-Run Growth? Technological Change Economic growth depends more on technological change than on increases in capital per hour worked. Technological change is an increase in the quantity of output firms can produce using a given quantity of inputs. Accumulating more inputs will NOT ensure that an economy experiences economic growth unless technological change also occurs. Entrepreneurs are import in implementing technological change. Government policies: Protecting private property, avoiding political instability……

10. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 34 Solved Problem 9-1 The Role of Technological Change in Growth Learning Objective 9.1 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 ?? 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 hour worked, 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.

11. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 34 Learning Objective 9.1 What Explains Rapid Economic Growth in Botswana? Making the Connection

12. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 34 Long-Run Economic Growth Learning Objective 9.1 Potential Real GDP Potential GDP The level of GDP attained when all firms are producing at capacity. The capacity is NOT the maximum output the firm is capable of producing. It is the output when the firm operates on normal hours, using normal workforce.

13. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 34 Long-Run Economic Growth Learning Objective 9.1 Potential Real GDP FIGURE 9.2 Actual and Potential Real GDP

14. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 34 Saving, Investment, and the Financial System Learning Objective 9.2 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.

15. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 34 Saving, Investment, and the Financial System Learning Objective 9.2 The Macroeconomics of Saving and Investment Y = C + I + G + NX For simplicity, we talk about a closed economy where NX=0. The U.S. is considered as a closed economy by economists. Y = C + I + G I = Y − C − G

16. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of 34 Saving, Investment, and the Financial System Learning Objective 9.2 The Macroeconomics of Saving and Investment Private saving: what households retain of their income after purchasing goods and services (C) and paying taxes (T). Households also receive income from government in the form of transfer payments (TR) S private = Y + TR − C − T Public saving: the amount of tax revenue (T) the government retains after paying for government purchases (G) and making transfer payments to households (TR). S public = T − G − TR S public =0, Balanced Budget S public >0, Budget Surplus: Clinton administration. S public <0, Budget Deficit: Bush administration.

17. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 34 Learning Objective 9.2 S = (Y + TR − C − T) + (T − G − TR) S = Y − C − G S = I Total saving (S): S=S private +S public or So, we can conclude that the total saving must equal to the total investment: Saving, Investment, and the Financial System The Macroeconomics of Saving and Investment

18. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 34 What we learned in our last class: Economic growth: Real GDP per capita Business cycle. Economic prosperity and health: life expectancy at birth lifetime hours of paid work and of leisure calculate growth rate and the rule of 70 What determines the long-run economic growth: Labor productivity: Capital per hour worked Technological change (more important) Entrepreneur Government policies (Botswana)

19. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 19 of 34 What we learned in our last class: Potential real GDP: at capacity--NORMAL level Financial system: funds flow from households to firms Saving and investment Private saving and public saving Balanced Budget, budget surplus and budget deficit Saving=Investment

20. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 20 of 34 Brief review on supply and demand curves Law of demand: Holding everything else constant, when the price of a product rises, the quantity demanded of the product decreases. Everything else: all variables or conditions other than price that may affect the willingness to buy. Demand curve (demand schedule) : The relationship between the price of a product and the quantity of the product demanded.

21. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 21 of 34 Brief review on supply and demand curves A change in demand: A shift of the demand curve (demand, demand schedule) A change in the relationship between the price of a product and the quantity demanded of the product A change in quantity demanded: A movement along the demand curve as a result of a change in the product’s price.

22. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 22 of 34 Brief review on supply and demand curves A change in demand vs. a change in quantity demanded A change in demand occurs if there is a change in one or more of the variables, other than the price of the product, that affect the willingness to buy. When everything else is constant and only the price of the product changes, the quantity demanded will move alone the demand curve, BUT the demand will NOT change, the demand curve will NOT shift!!!!!

23. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 23 of 34 Brief review on supply and demand curves Law of supply: Holding everything else constant, when the price of a product rises, the quantity supplied of the product increases. Everything else: all variables or conditions other than price that may affect the willingness to supply. Supply curve (supply schedule) : The relationship between the price of a product and the quantity of the product supplied.

24. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 24 of 34 Brief review on supply and demand curves A change in supply: A shift of the supply curve (supply, supply schedule) A change in the relationship between the price of a product and the quantity supplied of the product A change in quantity supplied: A movement along the supply curve as a result of a change in the product’s price.

25. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 25 of 34 Brief review on supply and demand curves A change in supply vs. a change in quantity supplied A change in supply occurs if there is a change in one or more of the variables, other than the price of the product, that affect the willingness to supply. When everything else is constant and only the price of the product changes, the quantity supplied will move alone the supply curve, BUT the supply will NOT change, the supply curve will NOT shift!!!!!

26. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 26 of 34 Saving, Investment, and the Financial System Learning Objective 9.2 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. Demand and supply in the loanable funds market: The demand for loanable funds is determined by the willingness of firms to borrow money. The supply of loanable funds is determined by the willingness of households to save and by the extent of government saving or dissaving (negative saving).

27. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 27 of 34 Learning Objective 9.2 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

28. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 28 of 34 Learning Objective 9.2 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 The Market for Loanable Funds

29. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 29 of 34 Learning Objective 9.2 Crowding out A decline in private expenditures as a result of an increase in government purchases. Explaining Movements in Saving, Investment, and Interest Rates Saving, Investment, and the Financial System The Market for Loanable Funds

30. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 30 of 34 Learning Objective 9.2 Explaining Movements in Saving, Investment, and Interest Rates 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

31. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 31 of 34 Solved Problem 9-2 How Would a Consumption Tax Affect Saving, Investment, the Interest Rate, and Economic Growth? Learning Objective 9.2

32. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 32 of 34 The Business Cycle Learning Objective 9.3 FIGURE 9.6 The Business Cycle Some Basic Business Cycle Definitions

33. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 33 of 34 Learning Objective 9.3 Who Decides if the Economy Is in a Recession? Making the Connection PEAKTROUGH LENGTH OF RECESSION July 1953May 195410 months August 1957April 19588 months April 1960February 196110 months December 1969November 197011 months November 1973March 197516 months January 1980July 19806 months July 1981November 198216 months July 1990March 19918 months March 2001November 20018 months

34. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 34 of 34 The Business Cycle Learning Objective 9.3 FIGURE 9.7 The Effect of the Business Cycle on Boeing What Happens during a Business Cycle? The Effect of the Business Cycle on Boeing

35. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 35 of 34 Learning Objective 9.3 FIGURE 9.8 The Effect of the 2001 Recession on the Inflation Rate The Effect of the Business Cycle on the Inflation Rate The Business Cycle What Happens during a Business Cycle?

36. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 36 of 34 Learning Objective 9.3 FIGURE 9.9 The Impact of Recessions on the Inflation Rate The Effect of the Business Cycle on the Inflation Rate Don’t Let This Happen to YOU! Don’t Confuse the Price Level and the Inflation Rate The Business Cycle What Happens during a Business Cycle?

37. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 37 of 34 Learning Objective 9.3 FIGURE 9.10 How the Recession of 2001 Affected the Unemployment Rate The Effect of the Business Cycle on the Unemployment Rate The Business Cycle What Happens during a Business Cycle?

38. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 38 of 34 Learning Objective 9.3 FIGURE 9.11 The Impact of Recessions on the Unemployment Rate The Effect of the Business Cycle on the Unemployment Rate The Business Cycle What Happens during a Business Cycle?

39. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 39 of 34 Learning Objective 9.3 FIGURE 9.12 Fluctuations in Real GDP, 1900–2006 Recessions Have Been Milder and the Economy Has Been More Stable Since 1950 The Business Cycle What Happens during a Business Cycle?

40. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 40 of 34 Learning Objective 9.3 Recessions Have Been Milder and the Economy Has Been More Stable Since 1950 Table 9-1 The Business Cycle Has Become Milder PERIOD AVERAGE LENGTH OF EXPANSIONS AVERAGE LENGTH OF RECESSIONS 1870-190026 months 1900-195025 months19 months 1950-200161 months9 months The Business Cycle What Happens during a Business Cycle?

41. Chapter 9: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 41 of 34 Learning Objective 9.3 The increasing importance of services and the declining importance of goods. The establishment of unemployment insurance and other government transfer programs that provide funds to the unemployed. Active federal government policies to stabilize the economy. The Business Cycle Why Is the Economy More Stable?