Principles of Macroeconomics - Chapter 10: Savings, Investments, and Financial Systems

Long-Run Economic Growth

The process by which rising productivity increases the average standard of living.

Real GDP per Capita

The amount of production in the economy per person, adjusted for changes in the price level.

Business Cycle

Alternating periods of economic expansion and economic recession.

Long-Run Growth vs. Business Cycle

Long-run growth is the upward trend in living standards; the business cycle consists of short-run expansions and recessions around that trend.

Two Main Sources of Long-Run Growth

Increases in capital per hour worked and technological change.

Labor Productivity

The quantity of goods and services that can be produced by one worker or by one hour of work.

Why Does Higher Labor Productivity Raise Living Standards?

Workers can produce more goods and services in the same amount of time.

Rule of 70

A shortcut for estimating how long it takes an economic variable to double.

Rule of 70 Formula

Years to double = 70 ÷ annual growth rate.

Rule of 70 Example

If the growth rate is 5%, the variable doubles in about 14 years.

Long-Run Growth Equation

Previous real GDP × (1 + g)^t = Current real GDP.

g in the Growth Equation

The average growth rate.

t in the Growth Equation

The number of time periods between the previous and current periods.

Potential GDP

The level of real GDP attained when firms operate at normal capacity with normal hours and a normal-sized workforce.

What Causes Potential GDP to Rise?

Expansion of the labor force, an increase in capital stock, or new technology.

Actual GDP During a Recession

Actual real GDP typically falls below potential GDP.

Financial System

The system of financial markets and financial intermediaries through which firms obtain funds from households.

Retained Earnings

Profits that a firm reinvests back into the firm to finance expansion.

Financial Market

A market where financial securities such as stocks and bonds are bought and sold.

Financial Security

A document stating the terms under which funds pass from the buyer of the security to the seller.

Stock

A financial security representing partial ownership of a firm.

Bond

A financial security promising repayment of a fixed amount of funds; essentially a loan from the buyer to the issuer.

Financial Intermediary

A firm that borrows funds from savers and lends those funds to borrowers.

Examples of Financial Intermediaries

Banks, mutual funds, pension funds, and insurance companies.

Three Services Provided by the Financial System

Risk sharing, liquidity, and information.

Risk Sharing

Spreading investments across many assets to reduce risk while maintaining expected return.

Liquidity

The ability to quickly convert an investment into cash.

Information Service of the Financial System

Security prices combine investors' beliefs about future returns and help direct funds toward firms.

GDP Expenditure Equation

Y = C + I + G + NX

Y in the GDP Equation

Income or GDP.

C in the GDP Equation

Consumption.

I in the GDP Equation

Investment.

G in the GDP Equation

Government purchases.

NX in the GDP Equation

Net exports.

Closed Economy

An economy assumed to have no exports or imports.

GDP Equation in a Closed Economy

Y = C + I + G

Investment Formula in a Closed Economy

I = Y − C − G

Private Saving

Household income that is not consumed or paid in taxes.

Private Saving Formula

Sprivate = Y + TR − C − T

Public Saving

The amount the government receives but does not spend.

Public Saving Formula

Spublic = T − G − TR

TR

Transfer payments.

T

Taxes.

Total Saving Formula

S = Sprivate + Spublic = Y − C − G

Relationship Between Saving and Investment in a Closed Economy

S = I

Saving Equals Investment

The total value of saving in a closed economy must equal the total value of investment.

Balanced Budget

A situation in which public saving equals zero; the government spends as much as it brings in.

Budget Deficit

A negative value of public saving; the government spends more than it brings in.

Budget Surplus

A positive value of public saving; the government brings in more than it spends.

Government Borrowing During a Deficit

The government finances deficits by borrowing, including selling Treasury bonds.

Effect of Government Deficits on Funds Available for Investment

Government borrowing reduces the funds available for private investment.

Market for Loanable Funds

A conceptual market where borrowers and lenders interact to determine the real interest rate and quantity of loanable funds.

Who Demands Loanable Funds?

Firms that want funds for investment.

Who Supplies Loanable Funds?

Households through saving; public saving also affects the supply.

Vertical Axis of the Loanable Funds Graph

Real interest rate.

Horizontal Axis of the Loanable Funds Graph

Quantity of loanable funds.

Loanable Funds Demand Curve

Downward sloping; firms borrow more when the real interest rate is lower.

Loanable Funds Supply Curve

Upward sloping; households save more when the real interest rate is higher.

Real Interest Rate and Borrowing

A lower real interest rate encourages firms to borrow more.

Real Interest Rate and Saving

A higher real interest rate rewards delayed consumption and encourages households to save more.

Equilibrium in the Loanable Funds Market

Where the supply and demand for loanable funds intersect.

Technological Change and Loanable Funds Demand

If technological change makes investment more profitable, demand for loanable funds shifts right.

Demand for Loanable Funds Shifts Right

Real interest rate rises and the quantity of loanable funds/investment increases.

Higher Expected Future Profits

Demand for loanable funds shifts right → real interest rate rises → investment increases.

Higher Corporate Taxes

Demand for loanable funds shifts left → real interest rate falls → investment decreases.

Government Budget Deficit

Supply of loanable funds shifts left → real interest rate rises → investment decreases.

Greater Desire to Consume Today

Supply of loanable funds shifts left → real interest rate rises → investment decreases.

Tax Benefits for Saving

Supply of loanable funds shifts right → real interest rate falls → investment increases.

401(k) Tax Benefits

An example of a policy that increases the incentive to save and shifts loanable-funds supply right.

Crowding Out

A decline in private expenditure resulting from increases in government purchases.

How Does a Budget Deficit Cause Crowding Out?

Government borrowing reduces the supply of loanable funds, raises the real interest rate, and reduces private investment.

Business Cycle

Alternating periods of expanding and contracting economic activity.

Expansion

A period during which real GDP is rising.

Recession

A period during which economic activity and real GDP are falling.

Peak

The point where an expansion ends and a recession begins.

Trough

The point where a recession ends and an expansion begins.

Typical Media Definition of a Recession

Two consecutive quarters of declining real GDP.

Who Officially Dates U.S. Business Cycles?

The National Bureau of Economic Research (NBER).

NBER Description of a Recession

A significant decline in economic activity spread across the economy and lasting more than a few months.

Indicators Considered by the NBER

Industrial production, employment, real income, and wholesale-retail trade.

Great Recession

The severe recession beginning in late 2007 and ending in mid-2009.

2020 Recession

A short but severe recession during the first months of the COVID-19 pandemic.

Near the End of an Expansion

Interest rates tend to rise, wages rise faster than other prices, and firm profits begin falling.

Beginning of a Recession

Firms reduce investment, households consume less, and firms cut employment.

Employment and Recession

Falling sales cause firms to reduce production and lay off workers.

Recovery from a Recession

Firms begin investing again in anticipation of an expansion, household spending improves, and employment eventually recovers.

Inflation Rate

The percentage change in the price level from one year to the next.

Inflation During an Expansion

Demand is high relative to supply, so inflation tends to increase.

Inflation During a Recession

Demand is lower relative to supply, so inflation tends to fall and prices may even decline.

Deflation

A decrease in the overall price level.

Typical Inflation Pattern in the Business Cycle

Inflation tends to rise near the end of an expansion and fall during a recession.

Typical Unemployment Pattern in a Recession

Unemployment rises as firms reduce production and lay off workers.

Unemployment After a Recession

Unemployment may continue rising even after the recession has officially ended.

Why Are Recessions Hard to Predict?

Business cycles are not uniform, leading indicators are unreliable, and the events that trigger recessions are difficult to predict.

Great Moderation

A period beginning around the mid-1980s when business-cycle fluctuations became relatively mild.

Business Cycles Before vs. After 1950

Annual fluctuations in real GDP were generally larger before 1950.

Increasing Importance of Services and Stability

Service industries are generally less affected by recessions than manufacturing, helping reduce fluctuations in GDP.

Unemployment Insurance and Economic Stability

Helps consumers continue purchasing goods and services during recessions.

Government Transfer Programs and Recessions

Programs such as unemployment insurance and Social Security help support household spending.

Stabilization Policies

Government policies intended to lengthen expansions and reduce the severity of recessions.