Economic Growth and Business Cycles in Economics

Economic Growth, the Financial System, and Business Cycles

Long-Run Economic Growth

  • Definition: Long-run economic growth refers to the sustained increase in a country's output of goods and services over time, typically measured by the rise in real GDP per capita.

  • Business Cycle:

    • Defined as the alternating periods of expansion and recession experienced by the economy.
    • Not uniform in length; expansions are followed by recessions and vice versa.
    • E.g., historical trends in the U.S. economy since the early 19th century.

  • Expectations of Growth:

    • Individuals in developed nations expect continuous improvement in their living standards, influenced by new product innovations and advancements in technology and health care.
    • Long-run economic growth leads to increased productivity and a higher average standard of living.

Growth in U.S. Real GDP Per Capita

  • Standard of Living: Measured by Real GDP per capita (the total economic output per person adjusted for price changes).
    • Example: Real GDP per capita rose more than eight-fold since 1900, significantly increasing consumption capacity of the average American.

Calculating Growth Rates

  • Growth Rate Calculation:

    • The growth rate = ((New Value - Old Value) / Old Value) × 100.
    • Example:
      • Real GDP in 2017 = $18,051 billion
      • Real GDP in 2018 = $18,566 billion
      • Growth Rate = ((18,566 - 18,051) / 18,051) × 100 ≈ 2.85%.

  • Doubling Time: Use the Rule of 70 to find out how long it will take for GDP per capita to double based on its growth rate.

    • Example: If growth rate = 5%, doubling time ≈ 70 / 5 = 14 years.

Determinants of Long-Run Growth

  • Labor Productivity:
    • Defined as goods and services produced per worker or per hour of work.
    • Factors influencing productivity:
    • Quantity of Capital: Refers to physical (machinery, buildings) and human capital (skills, knowledge).
    • Level of Technology: Technological advancements that increase output efficiency.

Saving, Investment, and the Financial System

  • Importance of Financial System:

    • Channels funds from savers to borrowers, enabling firms to invest and adopt new technologies critical for growth.

  • Financial Markets and Intermediaries:

    • Financial Markets: Where financial securities (stocks, bonds) are traded.
    • Stocks represent ownership in a company, bonds are promises to repay borrowed funds with interest.
    • Financial Intermediaries: Entities like banks that facilitate the flow of funds from savers to borrowers by pooling deposits for lending.

Key Services of the Financial System

  1. Risk Sharing: Allows savers to diversify investments to lower individual risk.
  2. Liquidity: Facilitates quick conversion of investments into cash.
  3. Information: Prices of financial securities reflect investor expectations regarding future cash flows.

The Macroeconomics of Savings and Investment

  • GDP Components:

    • GDP (Y) = Consumption (C) + Investment (I) + Government Purchases (G) + Net Exports (NX).
    • In a closed economy: Investment (I) = Saving (S) = Y - C - G.

  • Private and Public Savings:

    • Private Savings: Income retained after consumption and taxes.
    • Public Savings: Government revenues after expenditures.
    • Total Savings = Private Savings + Public Savings.

Savings Equals Investment

  • In a balanced budget scenario, savings must equal investments.
  • Budget Deficit: When government spending exceeds tax revenues; requires borrowing, affecting the supply of loanable funds.
  • Budget Surplus: Increases available savings for investment.

The Market for Loanable Funds

  • Market determined by the interaction of borrowers and lenders.
    • Demand: Driven by firms needing funds for investment; influenced by expected profitability.
    • Supply: Determined by households' willingness to save, influenced by interest rates.
  • Equilibrium: Occurs when quantity of loanable funds demanded equals quantity supplied, impacting interest rates.

Business Cycle Phases

  • Expansion: Increasing production, employment, income; characterized by high demand and potential inflation.
  • Recession: Declining production, employment; often follows excessive borrowing and spending, leading to layoffs and reduced demand.

Inflation and Unemployment during Business Cycle

  • Expansion Phase:
    • High demand leads to inflation and low unemployment.
  • Recession Phase:
    • Low demand leads to low inflation or deflation and high unemployment.