Chapter 6 - Economic Growth, the Financial System, and Business Cycles

Textbook + Lecture videos + hs notes

Economic Growth

The % increase in an economy’s total output (real GDP) is most appropriate when measuring an economy’s overall productive capacity.

How to measure economic Growth

Per Capita GDP (per person)

• Total GDP produced in a country in a given year / Population

• Countries with a higher GDP tend to have higher life expectancy and lower infant mortality rates

Growth Rate calculations (formula)

(This method is quicker and is useful during tests):  

(Final value / Initial value) –1  

Growth Rate of real GDP per capita

The % Change from the previous year

Compound Interest 

"Preview" example to average growth rates 

Compound interest example

• Suppose I put $1000 into a savings account, earning 4% interest per year. 

• How much will I have after 10 years? 

 

$1000 (1.04)^10 = 100 (1.48) 

 = $1480 

Rule of 70 

• How many years does it take for real GDP per capita to double?

• Formula:

  • 70 / Growth Rate

Rule of 70 - Example

If the growth rate is 3.7%, how many years does it take for real GDP per capita to double? 

 

70 / 3.7 = 18.9 years  

What are the sources of growth? 

• Labour productivity: Y/L 

  • Output per worker 

• Increasing capital (per labour hour) 

• Technological improvements 

• Property rights

Property rights

If a firm is assured that any investments it makes, either in capital stock or in R&D, it is more likely to undertake that spending, knowing it’ll make a profit.

Closed economy 

• A country that does not trade with other countries and does not allow capital to flow either in or out of its borders 

 Y = C + I + G 

• No "NX" term here

What is private saving?

The amount of income households have left after receiving transfer payments, paying taxes, and spending on consumption.

Formula for private saving (Sp)?

Sp = Y + TR − T − C

• Where:

  • Y = Income

  • TR = Transfer payments

  • T = Taxes

  • C = Consumption spending

What is Public saving?

Anything left over once the government has inflows from taxes, made transfer payments and purchased goods and services

Formula for Public saving (Sg)?

Sg = T − TR − G

• Where

  • T = Taxes collected (inflows of income from households)

  • TR = Transfer payments (outflows to households)

  • G = Government spending (on goods and services)

Definition of Saving: 

S = Sp + Sg 

National saving

National Saving = Investment  

(S = I)

Surplus Budget

• Tax revenue > Government spending + Transfer payments

• Flow variables 

Deficit Budget

• Tax revenue < Government spending + Transfer payments 

• Flow variables

Balanced Budget

Tax Revenue = Government spending + Transfer payments

Government debt

• An accumulation of past deficits  

• Stock variable

National Income Accounting Identity (Closed economy)

 Y = C + I + G

Market for Loanable Funds 

• Includes the market diagrams model

• Supply and demand for loanable funds --> brings savers and borrowers together.

Demand for Loanable Funds

Firms borrow funds in order to invest (purchase new capital goods) 

What is the slope of the demand for loanable funds?

Downward sloping

Why is the demand for loanable funds downward sloping?

Higher interest rates → higher borrowing cost → less investment.

Relationship between interest rate (r) and the demand for loanable funds?

Negative relationship.
Higher r → lower investment demand.

Demand for Loanable Funds - Shift factors 

When firms need/want to purchase less capital at any given interest rate, demand for LF decreases 

Supply of Loanable Funds

Savings made available for borrowing in the financial market by households and the government

Why do households supply loanable funds?

To earn interest on their savings.

What is the slope of the supply of loanable funds?

Upward sloping.

Why is the supply curve upward sloping?

Higher interest rates → more savings → more loanable funds supplied.

Supply of Loanable Funds - Shift factors

• When households/governments save MORE, the supply of LF increases.

• When households/governments save LESS, the supply of LF decreases. 

Does public saving depend on interest rates?

No.
Government saving is independent of interest rates.

Market Diagram

Components:
R = Real interest rates 

(Q) = Quantity of loanable funds

 

S = Savings  

Sp = Private savings 

Sg = Public saving 

I1 = S1 —> Savings = Investment

Potential GDP

The level of real GDP is attained when all firms are producing at capacity. 

• Capacity ≠ maximum possible output. 

• Capacity = production using: 

  • normal working hours 

  • a normal workforce 

Potential GDP increases when: 

• Labour force grows 

• New factories and machines are added 

• Technology improves labour

Output Gap

% difference between actual GDP and potential GDP (Bank of Canada). 

• Negative output gap: 

  • Actual GDP < potential GDP 

  • Unused resources, often during recessions 

• Positive output gap: 

  • Actual GDP > potential GDP 

  • Unsustainable production causes inflation