1. © 2007 Thomson South-Western

2. In this section, look for the answers to these questions: Why does productivity matter for living standards? What determines productivity and its growth rate? How can public policy affect growth and living standards? Financial System Market for Loanable Funds Govt. impacts to interest rates 1

3. © 2007 Thomson South-Western A typical family with all their possessions in the U.K., an advanced economy GDP per capita: $35,580 Life expectancy: 79 years Adult literacy: 99% GDP per capita: $35,580 Life expectancy: 79 years Adult literacy: 99%

4. © 2007 Thomson South-Western A typical family with all their possessions in Mali, a poor country GDP per capita: $1,130 Life expectancy: 50 years Adult literacy: 46% GDP per capita: $1,130 Life expectancy: 50 years Adult literacy: 46%

5. © 2007 Thomson South-Western 4 Incomes and Growth Around the World Questions: Why are some countries richer than others? Why do some countries grow quickly while others seem stuck in a poverty trap? What policies may help raise growth rates and long-run living standards?

6. © 2007 Thomson South-Western 5 Productivity Recall one of the Ten Principles from Chap. 1: A country’s standard of living depends on its ability to produce g&s. This ability depends on productivity, the average quantity of g&s produced per unit of labor input.

7. © 2007 Thomson South-Western 6 Why Productivity Is So Important When a nation’s workers are very productive, real GDP is large and incomes are high. When productivity grows rapidly, so do living standards. What, then, determines productivity and its growth rate? Human capital (H): the knowledge and skills workers acquire through education, training, and experience Productivity is higher when the average worker has more human capital (education, skills, etc.).

8. © 2007 Thomson South-Western 7 Productivity / Growth Rate Determinants Recall: The stock of equipment and structures used to produce g&s is called [physical] capital, denoted K. Productivity is higher when the average worker has more capital (machines, equipment, etc.). Natural resources (N): the inputs into production that nature provides, e.g., land, mineral deposits Some countries are rich because they have abundant natural resources (e.g., Saudi Arabia has lots of oil). But countries need not have much N to be rich (e.g., Japan imports the N it needs).

9. © 2007 Thomson South-Western 8 Technological Knowledge Technological knowledge: society’s understanding of the best ways to produce g&s Technological progress does not only mean a faster computer, a higher-definition TV, or a smaller cell phone. It means any advance in knowledge that boosts productivity (allows society to get more output from its resources). E.g., Henry Ford and the assembly line.

10. © 2007 Thomson South-Western Factor of Production Identification Identify factors of production seen in this photo.

11. © 2007 Thomson South-Western Which of the following policies do you think would be most effective at boosting growth and living standards in a poor country over the long run? a. Offer tax incentives for investment by local firms b. ” ” ” ” ” by foreign firms c. Give cash payments for good school attendance d. Crack down on govt corruption e. Restrict imports to protect domestic industries f. Allow free trade g. Give away condoms A C T I V E L E A R N I N G 1 Discussion Question

12. © 2007 Thomson South-Western ECONOMIC GROWTH AND PUBLIC POLICY Next, we look at the ways public policy can affect long-run growth in productivity and living standards.

13. © 2007 Thomson South-Western Saving and Investment We can boost productivity by increasing K, which requires investment. Since resources scarce, producing more capital requires producing fewer consumption goods. Reducing consumption = increasing saving. This extra saving funds the production of investment goods. (More details in the next chapter.) Hence, a tradeoff between current and future consumption.

14. © 2007 Thomson South-Western Output per worker (productivity) The Production Function & Diminishing Returns K/ L Y/ L Capital per worker If workers have little K, giving them more increases their productivity a lot. If workers already have a lot of K, giving them more increases productivity fairly little.

15. © 2007 Thomson South-Western Additional factors that can help development Foreign direct investment / foreign portfolio investment Education and R&D Health and Nutrition Property Rights and Political Stability Trade

16. © 2007 Thomson South-Western What about Population Growth? …may affect living standards in 3 different ways: 1.Stretching natural resources (ie. Malthus) 2.Diluting the capital stock 3.Promoting tech. progress

17. © 2007 Thomson South-Western Saving, Investment, and the Financial System The financial system consists of the group of institutions in the economy that help to match one person ’ s saving with another person ’ s investment. It moves the economy ’ s scarce resources from savers to borrowers.

18. © 2007 Thomson South-Western FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY The financial system is made up of financial institutions that coordinate the actions of savers and borrowers. Financial institutions can be grouped into two different categories: Financial markets (ie. Stock or Bond Markets) Financial intermediaries (ie. Banks or Mutual Funds)

19. © 2007 Thomson South-Western FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY Financial markets are the institutions through which savers can directly provide funds to borrowers. Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers.

20. © 2007 Thomson South-Western THE MARKET FOR LOANABLE FUNDS Financial markets coordinate the economy ’ s saving and investment in the market for loanable funds. The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds.

21. © 2007 Thomson South-Western Supply and Demand for Loanable Funds Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption. The supply of loanable funds comes from people who have extra income they want to save and lend out. The demand for loanable funds comes from households and firms that wish to borrow to make investments.

22. © 2007 Thomson South-Western Supply and Demand for Loanable Funds Interest rate the price of the loan the amount that borrowers pay for loans and the amount that lenders receive on their saving in the market for loanable funds, the real interest rate

23. © 2007 Thomson South-Western Supply and Demand for Loanable Funds Financial markets work much like other markets in the economy. The equilibrium of the supply and demand for loanable funds determines the real interest rate. The real interest rate: corrected for inflation the rate of growth in the purchasing power of a deposit or debt

24. © 2007 Thomson South-Western Figure 1 The Market for Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Supply Demand 5% $1,200

25. © 2007 Thomson South-Western Supply and Demand for Loanable Funds Government Policies That Affect Saving and Investment Taxes and saving Taxes and investment Government budget deficits and surpluses

26. © 2007 Thomson South-Western Policy 1: Saving Incentives Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save. A tax decrease increases the incentive for households to save at any given interest rate. The supply of loanable funds curve shifts right. The equilibrium interest rate decreases. The quantity demanded for loanable funds increases.

27. © 2007 Thomson South-Western Figure 2 An Increase in the Supply of Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Supply,S 1 S 2 2.... which reduces the equilibrium interest rate... 3.... and raises the equilibrium quantity of loanable funds. Demand 1. Tax incentives for saving increase the supply of loanable funds... 5% $1,200 4% $1,600

28. © 2007 Thomson South-Western Policy 1: Saving Incentives If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment.

29. © 2007 Thomson South-Western Policy 2: Investment Incentives An investment tax credit increases the incentive to borrow. Increases the demand for loanable funds. Shifts the demand curve to the right. Results in a higher interest rate and a greater quantity saved. If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving.

30. © 2007 Thomson South-Western Figure 3 Investment Incentives Increase the Demand for Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate 1. An investment tax credit increases the demand for loanable funds... 2.... which raises the equilibrium interest rate... 3.... and raises the equilibrium quantity of loanable funds. Supply Demand,D 1 D 2 5% $1,200 6% $1,400

31. © 2007 Thomson South-Western Policy 3: Government Budget Deficits and Surpluses When the government spends more than it receives in tax revenues, the short fall is called the budget deficit. The accumulation of past budget deficits is called the government debt.

32. © 2007 Thomson South-Western Policy 3: Government Budget Deficits and Surpluses Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by households and firms. This fall in investment is referred to as crowding out. The deficit borrowing crowds out private borrowers who are trying to finance investments.

33. © 2007 Thomson South-Western Policy 3: Government Budget Deficits and Surpluses A budget deficit decreases the supply of loanable funds. Shifts the supply curve to the left. Increases the equilibrium interest rate. Reduces the equilibrium quantity of loanable funds.

34. © 2007 Thomson South-Western Figure 4: The Effect of a Government Budget Deficit Loanable Funds (in billions of dollars) 0 Interest Rate 3.... and reduces the equilibrium quantity of loanable funds. S 2 2.... which raises the equilibrium interest rate... Supply,S 1 Demand $1,200 5% $800 6% 1. A budget deficit decreases the supply of loanable funds...

35. © 2007 Thomson South-Western Policy 3: Government Budget Deficits and Surpluses When government reduces national saving by running a deficit, the interest rate rises and investment falls. A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment.