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Long-Run Economic Growth

The process by which rising productivity increases the average standard of living in an economy over long periods.

Real GDP per Capita

Real GDP divided by the total population; the most commonly used metric to measure the average material standard of living; adjusted for inflation.

Labor Productivity

The quantity of goods and services that can be produced by one worker or by one hour of work. Growth in labor productivity is the key driver of long-run economic growth.

Capital (Physical Capital)

Manufactured goods used to produce other goods and services; such as machinery; factory buildings; tools; and delivery vehicles.

Human Capital

The accumulated knowledge; skills; education; and health that workers possess; which enhances their productive capacity.

Technological Change

An improvement in the ability of a firm to produce a given level of output with a given quantity of inputs; driven by better machinery; worker training; or organization.

Rule of 70

A mathematical shortcut to calculate the approximate number of years it takes for an economic variable to double: Doubling Time = 70 / (Annual Growth Rate in percent).

Potential GDP

The level of real GDP attained when all firms are operating at normal capacity (using normal working hours and a normal-sized labor force). It grows steadily over time (historically ~3.2% per year in the US).

Financial System

The framework of financial markets (e.g.; stock and bond markets) and financial intermediaries (e.g.; banks; mutual funds; insurance companies) through which firms acquire funds from households.

Financial Securities (Stocks vs. Bonds)

A stock represents partial legal ownership in a firm; a bond is a financial security representing a debt obligation promising to repay a fixed amount of funds with interest.

Three Key Services of the Financial System

1) Risk sharing (allowing savers to diversify assets); 2) Liquidity (ability to quickly convert assets into cash); 3) Information aggregation (market prices communicate future earnings expectations).

Savings-Investment Identity in a Closed Economy

In a closed economy where Y = C + I + G; Total Saving (S) must mathematically equal Investment (I): S = I.

Private Saving (Sprivate) Formula

Sprivate = Y + TR - C - T (Household income from production Y plus government transfers TR; minus consumption spending C and taxes paid T).

Public Saving (Spublic) Formula

Spublic = T - G - TR (Government tax revenue T; minus government purchases G and transfer payments TR).

Budget Deficit vs. Budget Surplus

A budget deficit occurs when Government spending exceeds tax revenue (T < G + TR); resulting in negative public saving (dissaving); a surplus occurs when T > G + TR (positive public saving).

Market for Loanable Funds

The conceptual financial market where borrowers (firms seeking investment capital) and lenders (households and governments supplying savings) interact to determine the equilibrium real interest rate.

Demand for Loanable Funds (Slope & Determinants)

Downward-sloping with respect to the real interest rate. Driven by business borrowing. Shifts RIGHT when expected future profits or technology rise; shifts LEFT when corporate taxes increase.

Supply of Loanable Funds (Slope & Determinants)

Upward-sloping with respect to the real interest rate. Driven by household saving and public saving. Shifts RIGHT when tax incentives for saving (e.g.; 401(k)) increase; shifts LEFT with government budget deficits or increased desire to consume today.

Crowding Out

A decline in private expenditures (especially business investment) caused by government budget deficits; which reduce national saving; shift loanable funds supply left; and increase the real interest rate.

Business Cycle

The alternating short-run periods of economic expansion and economic recession around the long-run potential GDP trend line.

Phases of the Business Cycle

Expansion (period of rising real GDP and employment) leading to a Peak; followed by a Recession (period of falling real GDP and employment) leading to a Trough.

NBER Definition of a Recession

A significant decline in economic activity spread across the economy; lasting more than a few months; normally visible in real GDP; real income; employment; industrial production; and wholesale-retail sales.

Behavior of Inflation Across the Business Cycle

Inflation tends to accelerate toward the end of an economic expansion as demand strains capacity; and decreases (disinflation) during recessions as demand softens.

Behavior of Unemployment Across the Business Cycle

Unemployment rises sharply during a recession and typically continues to rise even after the recession trough has passed; because firms are hesitant to rehire until recovery is sustained.

The Great Moderation

The period from the mid-1980s until 2007 characterized by unusually mild and stable business cycles; driven by the rise of the service sector; automatic stabilizers (unemployment insurance); and monetary stability.

Industrial Revolution

The historical application of mechanical power to the production of goods beginning in England around 1750; initiating modern sustained economic growth.

Per-Worker Production Function (Definition)

The economic relationship showing real GDP per hour worked (Y/L; on the vertical axis) as a function of capital per hour worked (K/L; on the horizontal axis); holding technology constant.

Axes of the Per-Worker Production Function

Vertical Y-axis: Real GDP per hour worked (Output per worker; Y/L). Horizontal X-axis: Capital per hour worked (K/L).

Shape and Slope of the Per-Worker Production Function

It is upward-sloping and concave (flattens out from left to right) due to the law of diminishing returns to capital.

Diminishing Marginal Returns to Capital

As capital per worker (K/L) increases; each additional unit of capital adds progressively smaller incremental increases to output per worker (Y/L); holding technology constant.

Movement Along the Per-Worker Production Function

Caused strictly by a change in capital per worker (K/L) when technology is fixed. It is subject to diminishing returns and cannot sustain growth indefinitely.

Shift of the Per-Worker Production Function (Upward)

Caused by Technological Change. An improvement in technology shifts the entire curve upward; enabling workers to produce more output per hour at EVERY level of capital per worker.

Capital Accumulation vs. Technological Change for Long-Run Growth

Capital accumulation alone cannot sustain long-run growth because of diminishing returns. Sustained long-run increases in living standards require continuous technological change.

Why the Soviet Union Failed Economically (Growth Model Context)

The Soviet Union relied heavily on capital accumulation rather than technological innovation; once capital stock was built up; growth collapsed due to severe diminishing returns and a lack of competitive incentives.

Developing vs. Developed Countries on the Per-Worker Curve

Developing countries with low K/L are on the steep initial portion (adding capital yields huge output gains); developed countries with high K/L are on the flat portion (gains from capital are small; growth requires technology).

Malthusian Theory vs. Solow Growth Model

Malthus tied output per worker solely to land; predicting mass starvation as population grew (proven wrong by modern technology). Solow based the per-worker model on capital per worker and technology.

Three Sources of Technological Change

1) Better machinery and equipment (e.g.; computers; microchips); 2) Increases in human capital (education; specialized training); 3) Better organization and management (e.g.; Just-In-Time production).

New Growth Theory (Paul Romer)

A model of long-run economic growth emphasizing that technological change is endogenous—driven by economic incentives; market profits; and the accumulation of knowledge capital.

Knowledge Capital (Rivalry & Excludability)

Unlike physical capital (which is rival and excludable; yielding diminishing returns); knowledge capital is nonrival and nonexcludable at the economy level; generating increasing returns.

The Free-Rider Problem in Knowledge Capital

Firms underinvest in research and development because other competing firms can freely copy their innovations without paying the full development cost; leading to an undersupply of private R&D.

Government Policies to Promote Knowledge Capital

1) Protecting intellectual property rights (patents and copyrights); 2) Subsidizing research and development (grants; NSF; NIH; tax credits); 3) Subsidizing education (public schooling; student aid).

Patent vs. Copyright Lifespans

A patent grants exclusive rights to produce/sell a product for 20 years from application date; a copyright grants exclusive creative rights for the creator's lifetime plus 70 years.

Creative Destruction (Joseph Schumpeter)

The continuous process whereby entrepreneurial innovation and new products destroy existing firms; outdated business models; and obsolete technologies (e.g.; smartphones replacing digital cameras).

The Catch-Up Hypothesis (Economic Convergence)

The economic prediction that poorer countries with lower starting GDP per capita will grow faster than rich countries; closing the income gap over time due to high returns on capital and imported technology.

Convergence Reality: High-Income vs. Developing Nations

Catch-up has successfully occurred among open high-income economies (e.g.; Japan; South Korea; Taiwan); but has largely failed to occur across the developing world as a whole.

Why the US Grows Faster than Other High-Income Countries

The US features more flexible labor markets (fewer hiring/firing restrictions; later retirement) and highly efficient; liquid financial systems with abundant venture capital.

Four Barriers to Economic Growth in Low-Income Countries

1) Failure to enforce the rule of law and secure property rights; 2) Political instability; wars; and revolutions; 3) Inadequate public education and poor healthcare; 4) Low domestic saving and investment rates.

Foreign Direct Investment (FDI) vs. Foreign Portfolio Investment

FDI involves a foreign corporation purchasing or building a physical facility in another country; Foreign Portfolio Investment involves buying foreign stocks; bonds; or debt securities.

Globalization and Economic Growth

The process of opening an economy to international trade and foreign capital flows. Developing nations that embraced globalization grew far faster than protectionist nations.

Aggregate Expenditure (AE) Model

A short-run Keynesian macroeconomic model focusing on the relationship between total spending and real GDP; assuming the price level is fixed.

Four Components of Aggregate Expenditure

Consumption (C); Planned Investment (I); Government Purchases (G); and Net Exports (NX). AE = C + I + G + NX.

Planned Investment vs. Actual Investment

Actual Investment includes unplanned changes in business inventories; whereas Planned Investment excludes unplanned inventory adjustments: I_actual = I_planned + Unplanned Inventory Changes.

Inventories (Definition & Economic Role)

Goods that have been produced by firms but not yet sold. Fluctuations in unplanned inventories act as the primary signal for firms to alter production.

Macroeconomic Equilibrium Condition (AE Model)

Occurs when Aggregate Expenditure equals total production: AE = Real GDP (Y); which implies Actual Investment equals Planned Investment and unplanned inventory changes are ZERO.

Adjustment When AE < GDP

Total spending is less than total output: unsold goods accumulate; inventories experience an unplanned RISE; prompting firms to cut production and employment; causing GDP to fall.

Adjustment When AE > GDP

Total spending exceeds total output: sales exceed expectations; inventories experience an unplanned FALL; prompting firms to ramp up production and hiring; causing GDP to rise.

Determinants of Consumption Spending (C)

1) Current disposable income (primary driver); 2) Household wealth; 3) Expected future income; 4) The price level; 5) The real interest rate.

Disposable Income Formula

Personal Income - Taxes + Transfer Payments (YD = Y - T + TR).

Wealth Effect on Consumption

A household's wealth is Assets minus Liabilities. Holding income constant; an increase in wealth increases consumption spending (roughly $40–$50 per $1;000 increase in wealth).

Consumption Smoothing

The economic behavior wherein households prefer to maintain a relatively stable level of consumption over their lifetimes rather than letting it fluctuate wildly with temporary income changes.

Why Spending on Consumer Durables is Highly Volatile

Durable goods (e.g.; cars; appliances) are expensive; long-lasting; financed with loans; easily postponed during recessions; and subject to pent-up demand during recoveries.

Consumption Function

The algebraic and graphical relationship showing how household consumption expenditure depends on disposable income (or national income).

Marginal Propensity to Consume (MPC)

The slope of the consumption function; the fraction of each additional dollar of disposable income that households spend on consumption: MPC = ΔC / ΔYD.

Marginal Propensity to Save (MPS)

The fraction of each additional dollar of disposable income that households save: MPS = ΔS / ΔYD. By identity; MPC + MPS = 1.

Determinants of Planned Investment (I)

1) Expectations of future business profitability; 2) Real interest rates (borrowing costs); 3) Corporate taxes and investment tax credits; 4) Cash flow (retained earnings/profits).

Cash Flow (Definition & Investment Link)

The difference between cash revenues received by a firm and cash spending. During recessions; profits and cash flow drop sharply; restricting firms' ability to fund investments.

Government Purchases (G) in the AE Model

Autonomous spending by federal; state; and local governments on goods and services; explicitly excludes government transfer payments like Social Security.

Determinants of Net Exports (NX)

1) Relative price levels (higher US inflation reduces NX); 2) Relative GDP growth rates (faster US growth reduces NX); 3) Exchange rates (a stronger US dollar makes exports expensive and imports cheap; reducing NX).

The 45-Degree Line Diagram (Keynesian Cross)

A graph plotting Real Aggregate Expenditure on the vertical axis against Real GDP on the horizontal axis; any point on the 45-degree line represents an equilibrium where AE = GDP.

Recession on the 45-Degree Line Diagram

Occurs when the AE line intersects the 45-degree line at an equilibrium real GDP level that lies strictly below the economy's potential GDP.

Autonomous Expenditure vs. Induced Expenditure

Autonomous expenditure does not depend on real GDP (I; G; NX; and baseline consumption); induced expenditure changes proportionally with real GDP (MPC × Y).

The Multiplier Effect

The process by which an initial change in autonomous expenditure causes a larger; multiplied change in equilibrium real GDP through successive rounds of induced spending.

Simple Multiplier Formula

Multiplier = 1 / (1 - MPC) = 1 / MPS = ΔReal GDP / ΔAutonomous Expenditure.

Calculating Change in Equilibrium GDP with the Multiplier

ΔY = Multiplier × ΔAutonomous Expenditure. For example; if MPC = 0.75; Multiplier = 4; a $200B increase in investment yields an $800B increase in GDP.

Relationship Between MPC and the Multiplier

The larger the MPC; the larger the multiplier effect; because a greater portion of each round of newly generated income is spent on induced consumption rather than saved.

Real-World Multiplier vs. Simple Multiplier

The real-world multiplier is significantly smaller than 1 / (1 - MPC) because real-world spending leaks into income taxes; imported goods; interest rate increases; and inflation.

The Paradox of Thrift

Keynes's proposition that while saving is beneficial for long-term growth; if all households attempt to save more simultaneously in the short run; aggregate spending falls; causing a recession that leaves total saving unchanged or lower.

Deriving the Aggregate Demand (AD) Curve from the AE Model

An increase in price level shifts the AE line downward (reducing real wealth; raising interest rates; and lowering NX); causing equilibrium real GDP to fall—producing the downward-sloping AD curve.

Algebra of Equilibrium Real GDP (Closed Economy)

If C = C_bar + MPC(Y); then Y = C_bar + MPC(Y) + I_bar + G_bar + NX_bar. Solving for Y yields: Y = (C_bar + I_bar + G_bar + NX_bar) / (1 - MPC).

Money (Economic Definition)

Any asset that people are generally willing to accept in exchange for goods and services or for payment of debts.

Barter Economy

An economic system where goods and services are traded directly for other goods and services without using money.

Double Coincidence of Wants

The central requirement of barter: for trade to occur; each party must want exactly what the other is offering. It imposes massive search and transaction costs.

Four Primary Functions of Money

1) Medium of exchange; 2) Unit of account; 3) Store of value; 4) Standard of deferred payment.

Medium of Exchange

The primary function of money: an asset buyers give to sellers in exchange for goods and services; eliminating the need for a double coincidence of wants.

Unit of Account

The monetary yardstick or standard numerical unit used to measure; quote; and compare the market value of goods; services; and economic transactions.

Store of Value

An asset that allows purchasing power to be transferred from the present into the future; money is the most liquid store of value; though its purchasing power is eroded by inflation.

Standard of Deferred Payment

The property of money that allows it to facilitate borrowing and lending across time; enabling debts and contracts to be specified in future monetary terms.

Five Criteria for a Good to Serve as a Medium of Exchange

1) Acceptable to most people; 2) Standardized quality (identical units); 3) Durable (does not spoil or decay); 4) Valuable relative to weight (easily portable); 5) Divisible (usable for large and small purchases).

Commodity Money

Money that possesses intrinsic value independent of its use as currency (e.g.; gold coins; silver bullion; cigarettes in WWII prisoner-of-war camps).

Fiat Money

Money authorized by a central bank or government that has no intrinsic value and is not redeemable for an underlying commodity like gold; backed purely by public trust and legal tender status.

M1 Money Supply (Components)

The narrowest measure of money supply; consisting of: 1) Physical currency in circulation (outside bank vaults); 2) Checking account deposits (demand deposits and other checkable deposits); 3) Traveler's checks (negligible).

M2 Money Supply (Components)

A broader measure of the money supply consisting of: 1) All of M1; 2) Savings account deposits (including Money Market Deposit Accounts); 3) Small-denomination time deposits (CDs under $100;000); 4) Non-institutional/retail money market mutual fund balances.

Why Credit Cards Are NOT Money

A credit card is a method of deferred payment that authorizes an instant pre-approved short-term loan from a bank. No money changes hands at purchase; the debt is settled later using actual money (checking deposits).

Are Debit Cards Money?

The plastic card itself is not money; it is an electronic access instruction that transfers funds directly from the cardholder's checking account (which IS part of M1).

Why Bitcoin / Cryptocurrencies Are NOT Considered True Money

Bitcoin fails key criteria of money: its extreme price volatility makes it a poor store of value and unit of account; and it lacks widespread acceptance as a medium of exchange. It behaves as a speculative asset.

Liquidity (Definition & Money Supply Ranking)

The ease with which an asset can be converted into cash without loss of value. M1 assets possess the highest liquidity; followed by M2 assets.