1. © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 1 of 331 of 40 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Economic Growth, the Financial System, and Business Cycles CHAPTER 10 Chapter Outline and Learning Objectives 10.1Long-Run Economic Growth 10.2Saving, Investment, and the Financial System 10.3The Business Cycle

2. © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 332 of 40 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Discuss the importance of long-run economic growth. 10.1 LEARNING OBJECTIVE Long-Run Economic Growth

3. Chapter 21: 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 Long-Run Economic Growth Learning Objective 10.1 Long-run economic growth The process by which rising productivity increases the average standard of living. FIGURE 10.1 The Growth in Real GDP per Capita, 1900–2006

4. Chapter 21: 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 Learning Objective 10.1 The Connection between Economic Prosperity and Health Making the Connection

5. Chapter 21: 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 Annual Percent Change YearReal GDPPotential GDP 1999$ 9,470$ 9,281 2000$ 9,817$ 9,634 2001$ 9,891$ 9,991 2002$10,049$10,342 2003$10,321$10,677 Annual Percent Change in Real GDP: ((Current value – Prior Year Value) / Prior Year Value) x 100 Example: Annual Percent Change for real GDP from 1999 to 2000: Average Percent Change from 1999 to 2003:

6. Chapter 21: 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 Long-Run Economic Growth Learning Objective 10.1 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.

7. Chapter 21: 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 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. Why can the average American consume eight times as many goods and services now, as in 1900? Because the average American produces eight times as many goods and services in an hour now, as in 1900. 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?” What determines the rate of long-run growth?

8. Chapter 21: 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 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. 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. Factors affecting labor productivity growth

9. Chapter 21: 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 10.1 Potential Real GDP Potential GDP The level of GDP attained when all firms are producing at capacity. Potential GDP rises when… The growth in potential GDP in the U.S. has been relatively steady at about 3.3%; that is, the potential to produce final goods and services has been growing in the U.S. at about this rate over time.

10. Chapter 21: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 3410 of 40 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Figure 10.2 Actual and potential GDP in the United States

11. Chapter 21: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 3411 of 40 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Discuss the role of the financial system in facilitating long-run economic growth. 10.2 LEARNING OBJECTIVE Saving, Investment, and the Financial System

12. Chapter 21: 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 Saving, Investment, and the Financial System Learning Objective 10.2 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.

13. Chapter 21: 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 The financial system provides three key services: Risk-sharing Liquidity Information Three key services of the financial system

14. Chapter 21: 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 10.2 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

15. Chapter 21: 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 Learning Objective 10.2 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

16. Chapter 21: 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 10.2 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.

17. Chapter 21: 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 10.2 Ebenezer Scrooge: Accidental Promoter of Economic Growth? Making the Connection Who was better for economic growth: Scrooge the saver or Scrooge the spender?

18. Chapter 21: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 3418 of 40 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Explain what happens during the business cycle. 10.3 LEARNING OBJECTIVE The Business Cycle

19. Chapter 21: 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 Economic Growth, the Financial System, and Business Cycles Business cycle Alternating periods of economic expansion and economic recession. While real GDP per capita has risen about eight-fold since the start of the 20 th century, it has not risen consistently every year. Since at least the early 19 th century, the American economy has experienced alternating periods of expanding and contracting economic activity.

20. Chapter 21: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 20 of 3420 of 40 © 2013 Pearson Education, Inc. Publishing as Prentice Hall The business cycle

21. Chapter 21: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 21 of 3421 of 40 © 2013 Pearson Education, Inc. Publishing as Prentice Hall The business cycle, 2005-2011 This figure shows the movements in real GDP in the U.S. from 2005 to 2011. 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.

22. Chapter 21: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 22 of 3422 of 40 © 2013 Pearson Education, Inc. Publishing as Prentice Hall 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 December 2007June 200918 months Table 10.1 The federal government does not define when a recession starts or ends. The typical media definition of a recession is “two consecutive quarters of declining real GDP. How do we known when the economy is in a recession? However most economists defer to the judgment of the National Bureau of Economic Research: “A recession is a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade.” NBER-defined recessions since 1950

23. Chapter 21: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 23 of 3423 of 40 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Historically, recessions have generally been followed by periods of strong economic growth. Some firms take advantage of the low real interest rates that typically accompany a recession to make investments by expanding productive capacity, effectively betting that the growth will justify their investments. Can a Recession Be a Good Time for a Business to Expand? Making the Connection For example, computer chip maker Intel decided in early 2009 to proceed with a $7 billion expansion of its U.S. factories. Heavy equipment manufacturer Caterpillar acted similarly, expanding in order “to meet the expected increase in customer demand”.

24. Chapter 21: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 24 of 3424 of 40 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Boeing makes aircraft—very much a durable good. So we expect their sales to be strongly affected by recessions. The effect of the business cycle on Boeing The charts show this prediction to be accurate—though Boeing was less affected by the recession of 2007-2009 than we might have expected; overseas demand remained strong in this period.

25. Chapter 21: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 25 of 3425 of 40 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Notice that inflation tends to rise toward the end of an expansion, and fall over the course of each recession. The effect of the business cycle on inflation—graph (red bars indicate recession)

26. Chapter 21: 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 As firms see their sales start to fall in a recession, they generally reduce production and lay off workers. The effect of the business cycle on unemployment Notice that unemployment often continues to rise, even after the end of each recession. (red bars indicate recession)

27. Chapter 21: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 27 of 3427 of 40 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Figure 10.10 Annual fluctuations in real GDP were typically greater before 1950 than after 1950. Economists refer to this as the “Great Moderation”. Fluctuations in real GDP: 1900-2010

28. Chapter 21: 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 10.3 Recessions Have Been Milder and the Economy Has Been More Stable Since 1950 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?

29. Chapter 21: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 29 of 3429 of 40 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Explaining the Great Moderation Several factors help to explain the Great Moderation: The increasing importance of services Manufacturing (especially of durable goods) is more strongly affected by recessions. The economy is based more on services now, decreasing the effect of the business cycle on GDP. The establishment of unemployment insurance Before the 1930s, unemployment insurance and other government transfer programs like Social Security did not exist. These programs increase the ability of consumers to purchase goods and services during recessions. Active federal government stabilization policies Increased stability of the financial system

30. Chapter 21: Economic Growth, the Financial System, and Business Cycles © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 30 of 3430 of 40 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Explaining the Great Moderation Several factors help to explain the Great Moderation: The increasing importance of services The establishment of unemployment insurance Active federal government stabilization policies Many, though not all, economists believe that active government policies to lengthen expansions and minimize the effects of recessions have had the desired effect. The debate over the role of government in this way became particularly intense during the recession of 2007-2009. Increased stability of the financial system The severity of the Great Depression of the 1930s was in part caused by instability in the financial system; similar instability exacerbated the recession of 2007-2009. Returning to macroeconomic stability will require a stable financial system.