Education
 Govt can increase productivity by promoting
education–investment in human capital (H).
• public schools, subsidized loans for college
 Education has significant effects: In the U.S., each
year of schooling raises a worker’s wage by 10%.
 But investing in H also involves a tradeoff
between the present & future:
Spending a year in school requires
sacrificing a year’s wages now
to have higher wages later.
CHAPTER 25
PRODUCTION AND GROWTH
0
Health and Nutrition
 Health care expenditure is a type of
investment in human capital – healthier
workers are more productive.
 In countries with significant malnourishment,
raising workers’ caloric intake raises
productivity:
• Over 1962-95, caloric consumption rose
44% in S. Korea, and economic growth
was spectacular.
CHAPTER 25
PRODUCTION AND GROWTH
1
caloric consumption
CHAPTER 25
PRODUCTION AND GROWTH
2
Nobel winner Robert Fogel
 30% of Great
Britain’s growth
from 1790-1980
was due to
improved nutrition.
CHAPTER 25
PRODUCTION AND GROWTH
3
Property Rights and Political Stability
 Recall: Markets are usually a good
way to organize economic activity.
The price system allocates resources
to their most efficient uses.
 This requires respect for property rights,
the ability of people to exercise authority
over the resources they own.
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PRODUCTION AND GROWTH
4
Property Rights and Political Stability
 In many poor countries, the justice system doesn’t
work very well:
•
•
•
contracts aren’t always enforced
fraud, corruption often go unpunished
in some, firms must bribe govt officials for permits
 Political instability (e.g., frequent coups) creates
uncertainty over whether property rights will be
protected in the future.
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PRODUCTION AND GROWTH
5
Property Rights and Political Stability
 When people fear their capital may be stolen by
criminals or confiscated by a corrupt govt,
there is less investment, including from abroad,
and the economy functions less efficiently.
Result: lower living standards.
 Economic stability, efficiency, and healthy growth
require law enforcement, effective courts,
a stable constitution, and honest govt officials.
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PRODUCTION AND GROWTH
6
Free Trade
 Inward-oriented policies
(e.g., tariffs, limits on investment from abroad) aim to
raise living standards by avoiding interaction with other
countries.
 Outward-oriented policies (e.g., the elimination of
restrictions on trade or foreign investment) promote
integration with the world economy.
 The World Trade Organization is the only global
international organization dealing with the rules of trade
between nations. At its heart are the WTO agreements,
negotiated and signed by the bulk of the world’s trading
nations and ratified in their parliaments.
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PRODUCTION AND GROWTH
7
CHAPTER 25
PRODUCTION AND GROWTH
8
Free Trade
 Recall: Trade can make everyone better off.
 Trade has similar effects as discovering new
technologies – it improves productivity and living
standards.
 Countries with inward-oriented policies have
generally failed to create growth.
• e.g., Argentina during the 20th century.
 Countries with outward-oriented policies have
often succeeded.
• e.g., South Korea, Singapore, Taiwan after 1960.
CHAPTER 25
PRODUCTION AND GROWTH
9
Now, the key
“ I am looking for a lot of men who have
infinite capacity to not know what
can't be done.”
-- Henry Ford
CHAPTER 25
PRODUCTION AND GROWTH
10
Research and Development
 Technological progress is the main reason why
living standards rise over the long run.
 One reason is that knowledge is a public good:
Ideas can be shared freely, increasing the
productivity of many.
 Policies to promote tech. progress:
• patent laws
• tax incentives or direct support for
•
private sector R&D
grants for basic research at universities
CHAPTER 25
PRODUCTION AND GROWTH
11
Population Growth
…may affect living standards in 3
different ways:
1. Stretching natural resources
 200 years ago, Malthus argued
that pop. growth would strain
society’s ability to provide for
itself.
 Since then, the world population
has increased sixfold. If Malthus
was right, living standards would
have fallen. Instead, they’ve
risen.
 Malthus failed to account for
technological progress and
productivity growth.
CHAPTER 25
PRODUCTION AND GROWTH
12
Population Growth
2. Diluting the capital stock
 more population = higher L = lower K/L
= lower productivity & living standards.
 This applies to H as well as K:
fast pop. growth = more children
= greater strain on educational system.
 Countries with fast pop. growth tend to have lower
educational attainment.
CHAPTER 25
PRODUCTION AND GROWTH
13
Population Growth
2. Diluting the capital stock
To combat this, many
developing countries use
policy to control population
growth.
CHAPTER 25
•
China’s one child per
family laws
•
contraception education
& availability
•
promote female literacy to
raise opportunity cost of
having babies
PRODUCTION AND GROWTH
14
Population Growth
3. Promoting tech. progress
 More people
= more scientists, inventors, engineers
= more frequent discoveries
= faster tech. progress & economic growth
 Over the course of human history,
• growth rates increased as the world’s
•
population increased
more populated regions grew faster than
less populated ones
CHAPTER 25
PRODUCTION AND GROWTH
15
ACTIVE LEARNING
Productivity
2:
 List the determinants of productivity.
 List three policies that attempt to raise living
standards by increasing one of the determinants
of productivity.
16
ACTIVE LEARNING
Answers
2:
Determinants of productivity:
physical capital per worker (K/L)
human capital per worker (H/L)
natural resources per worker (N/L)
technological knowledge (A)
Policies to boost productivity:
 Encourage saving and investment, to raise K/L
 Encourage investment from abroad, to raise K/L
 Provide public education, to raise H/L
17
ACTIVE LEARNING
Answers
2:
Determinants of productivity:
physical capital per worker (K/L)
human capital per worker (H/L)
natural resources per worker (N/L)
technological knowledge (A)
Policies to boost productivity:
 Patent laws or grants, to increase A
 Control population growth, to increase K/L
18
Are Natural Resources a Limit to Growth?
 Some argue that population growth is depleting the
Earth’s non-renewable resources, and thus will limit
growth in living standards.
 But technological progress often yields ways to
avoid these limits:
•
•
Hybrid cars use less gas.
Better insulation in homes reduces the energy
required to heat or cool them.
 As a resource becomes scarcer, its market price
rises, which increases the incentive to conserve it
and develop alternatives.
CHAPTER 25
PRODUCTION AND GROWTH
19
CONCLUSION
 In the long run, living standards are determined by
productivity.
 Policies that affect the determinants of productivity
will therefore affect the next generation’s living
standards.
 One of these determinants is saving and
investment.
 In the next chapter, we will learn how saving and
investment are determined, and how policies can
affect them.
CHAPTER 25
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20
We have…
 Realized that capital accumulation is one of the
driving forces for growth.
Now…
 We explore the ECONOMICS of capital
accumulation.
• Why would firms purchase capital?
• Where does the capital come?
CHAPTER 25
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22
26
Saving, Investment, and the
Financial System
PRINCIPLES OF
ECONOMICS
FOURTH EDITION
N. G R E G O R Y M A N K I W
PowerPoint® Slides
by Ron Cronovich
© 2007 Thomson South-Western, all rights reserved
In this chapter, look for the answers to
these questions:
 What are the main types of financial institutions
in the U.S. economy, and what is their function?
 What are the three kinds of saving?
 What’s the difference between saving and
investment?
 How does the financial system coordinate saving
and investment?
 How do govt policies affect saving, investment,
and the interest rate?
CHAPTER 25
PRODUCTION AND GROWTH
24
Robinson-Crusoe Economy Again…
CHAPTER 25
PRODUCTION AND GROWTH
25
Saving of Robinson
 Robinson lives alone;
 He makes a living by fishing;
•
Notice that Robinson is the producer AND the consumer;
or, in another word, he is the firm AND the household.
 Suppose fish is storable. Robinson can either eat all the fish
he catches, or eat part of it and store the rest – Robinson
Saves!
 Why would he save? Notice that Robinson has to eat some
fish everyday to keep himself alive.
• He knows he may get sick one day; (save for
unemployment)
• He may need a break the next day; (save for vacation)
• He plans to make fishnets the next day to catch more
fishes in the future – Robinson invests! (save for
investment).
CHAPTER 25
PRODUCTION AND GROWTH
26
Now, make it more real…
 Fish can be storable, but not for ever.
 In the real world, capital depreciates.
 If we make the extreme assumption that fish is
non-storable, can Robinson save?
CHAPTER 25
PRODUCTION AND GROWTH
27
Yes, he can; but not alone
 Suppose there are two Robinsons.
Robinson 1
CHAPTER 25
PRODUCTION AND GROWTH
Robinson 2
28
Two Robinsons can make arrangement
 Robinson 1 gets sick one day and cannot catch
fish.
 Robinson 2 helps him out by sharing fish with
him
 But Robinson 1 makes the promise that he will
return the fish back once he recovers and fishes
again.
 In this case, Robinson 1 is the borrower and
Robinson 2 is the saver.
 The income of the saver goes to the borrower.
CHAPTER 25
PRODUCTION AND GROWTH
29
Two Robinsons can make another
arrangement…
 Robinson 1 wants to spend a day making
fishnets to catch more fish in the future;
 Robinson 2 helps Robinson 1 by sharing fish
with him; Robinson 1 promises that he will give
the fish back.
 In this case, Robinson 2 is still the saver, but
Robinson 1 is the investor.
 The investment is financed by saving!
CHAPTER 25
PRODUCTION AND GROWTH
30
When there are only two Robinsons
 They talk and make arrangement;
When there are millions of people as
in the real world…
 Things take place through MARKET;
 In this case, firms’ investment are financed by
households’ saving through FINANCIAL
MARKETS or FINANCIAL INTERMEDIARIES –
together they constitute financial system
CHAPTER 25
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31
Financial Institutions
 The financial system: the group of
institutions that helps match the saving of
one person with the investment of another.
• Direct interaction – Financial Markets
(bonds market, stock market)
• Indirect interaction – Financial
Intermediaries. (banks, mutual funds)
CHAPTER 25
PRODUCTION AND GROWTH
32
Direct interaction between savors and
borrowers
 Financial markets: institutions through
which savers can directly provide funds to
borrowers. Examples:
• The Bond Market.
A bond is a certificate of indebtedness.
• The Stock Market.
A stock is a claim to partial ownership in
a firm.
CHAPTER 25
PRODUCTION AND GROWTH
33
A BOND
 Date of maturity: the time when the loan will be
paid;
 Rate of interest that will be paid periodically until
the loan matures.
 Bonds are risky!
CHAPTER 25
PRODUCTION AND GROWTH
34
The Stock Market
 Partial ownership by funding the purchase of
capital;
 Declares share of the corporate profits;
 Stocks are riskier than bonds, why?
• Bond represents a firm’s obligation to pay the
•
•
money back.
Investors take the risks themselves by
purchasing the partial ownership.
Before a firm goes bankrupt, its remaining
assets are used first to pay off the debts.
CHAPTER 25
PRODUCTION AND GROWTH
36
Stock Exchange
 Once stocks are issued, they change owners via
the stock exchange market.
• NY Stock Exchange
• American Stock Exchange
• NASDAQ
 Stock price of a firm depends on
• The firms’ profitability
• People’s perception for the firms’ future.
CHAPTER 25
PRODUCTION AND GROWTH
37
1929 Crash of the NY Stock Exchange
during the Great Depression
CHAPTER 25
PRODUCTION AND GROWTH
38
NASDAQ: the world’s biggest electronic
stock exchange system
CHAPTER 25
PRODUCTION AND GROWTH
39
Stock Price Indexes
 Just like GDP deflator is the average price for all
goods and services produced in the US;
 Stock price indexes is the average price of
different companies’ stock prices.
 Depending on which companies’ stock price is
included, we have:
• Dow Jones Industrial Average: 30 major US
companies such as GM, AT&T…
• Standard&Poor’s 500 Index: 500 major
companies.
CHAPTER 25
PRODUCTION AND GROWTH
40
Financial Institutions
 Financial intermediaries: institutions through
which savers can indirectly provide funds to
borrowers. Examples:
• Banks that take deposits from the households
and make loans to firms.
• Mutual funds – institutions pool savings from
the public that is invested and managed on their
behalf by professional money managers.
CHAPTER 25
PRODUCTION AND GROWTH
41
Mutual Funds
CHAPTER 25
PRODUCTION AND GROWTH
42
Different Kinds of Saving
Private saving
= The portion of households’ income that is
not used for consumption or paying taxes
=Y–T–C
Public saving
= Tax revenue less government spending
=T–G
CHAPTER 25
PRODUCTION AND GROWTH
43
National Saving
National saving
= private saving + public saving
=
(Y – T – C) +
=
(T – G)
Y – C – G
= the portion of national income that is not used
for consumption or government purchases
CHAPTER 25
PRODUCTION AND GROWTH
44
Saving and Investment
Recall the national income accounting identity:
Y = C + I + G + NX (-5.8%)
For the rest of this chapter, focus on the closed
economy case:
Y=C+I+G
national saving
Solve for I:
I = Y–C–G
= (Y – T – C) + (T – G)
Saving = investment in a closed economy
CHAPTER 25
PRODUCTION AND GROWTH
45
Budget Deficits and Surpluses
Budget surplus
= an excess of tax revenue over govt spending
= T–G
= public saving
Budget deficit
= a shortfall of tax revenue from govt spending
= G–T
= – (public saving)
CHAPTER 25
PRODUCTION AND GROWTH
46
ACTIVE LEARNING
Exercise
1:
 Suppose GDP equals $10 trillion,
consumption equals $6.5 trillion,
the government spends $2 trillion
and has a budget deficit of $300 billion.
 Find public saving, taxes, private saving,
national saving, and investment.
CHAPTER 25
PRODUCTION AND GROWTH
47
ACTIVE LEARNING
Answers
Given:
Y = 10.0,
C = 6.5,
1:
G = 2.0,
G – T = 0.3
Public saving = T – G = – 0.3
Taxes: T = G – 0.3 = 1.7
Private saving = Y – T – C = 10 – 1.7 – 6.5 = 1.8
National saving = Y – C – G = 10 – 6.5 = 2 = 1.5
Investment = national saving = 1.5
CHAPTER 25
PRODUCTION AND GROWTH
48
ACTIVE LEARNING
Exercise
1B:
 Now suppose the government cuts taxes by
$200 billion.
 In each of the following two scenarios,
determine what happens to public saving,
private saving, national saving, and investment.
1. Consumers save the full proceeds of the
tax cut.
2. Consumers save 1/4 of the tax cut and
spend the other 3/4.
CHAPTER 25
PRODUCTION AND GROWTH
49
ACTIVE LEARNING
Answers
1B:
In both scenarios, public saving falls by
$200 billion, and the budget deficit rises
from $300 billion to $500 billion.
1. If consumers save the full $200 billion,
national saving is unchanged,
so investment is unchanged.
2. If consumers save $50 billion and spend
$150 billion, then national saving and
investment each fall by $150 billion.
CHAPTER 25
PRODUCTION AND GROWTH
50
ACTIVE LEARNING
Discussion questions
1C:
The two scenarios are:
1. Consumers save the full proceeds of the
tax cut.
2. Consumers save 1/4 of the tax cut and
spend the other 3/4.
 Which of these two scenarios do you think is the
most realistic?
 Why is this question important?
CHAPTER 25
PRODUCTION AND GROWTH
51
The Meaning of Saving and Investment
 Private saving is the income remaining after
households pay their taxes and pay for
consumption.
 Examples of what households do with saving:
• buy corporate bonds or equities
• purchase a certificate of deposit at the bank
• buy shares of a mutual fund
• let accumulate in saving or checking accounts
CHAPTER 25
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52
The Meaning of Saving and Investment
 Investment is the purchase of new capital.
 Examples of investment:
• General Motors spends $250 million to build
a new factory in Flint, Michigan.
• You buy $5000 worth of computer equipment
for your business.
• Your parents spend $300,000 to have a new
house built.
Remember: In economics, investment is NOT
the purchase of stocks and bonds!
CHAPTER 25
PRODUCTION AND GROWTH
53
The Market for Loanable Funds
 A supply-demand model of the financial system.
 Helps us understand
• how the financial system coordinates
saving & investment
• how govt policies and other factors affect
saving, investment, the interest rate
CHAPTER 25
PRODUCTION AND GROWTH
55
The Market for Loanable Funds
Assume: only one financial market.
• All savers deposit their saving in this market.
• All borrowers take out loans from this market.
• There is one interest rate, which is both the
return to saving and the cost of borrowing.
CHAPTER 25
PRODUCTION AND GROWTH
56
The Market for Loanable Funds
The supply of loanable funds comes from saving:
• Households with extra income can loan it out
and earn interest.
• Public saving, if positive, adds to national
saving and the supply of loanable funds.
If negative, it reduces national saving and the
supply of loanable funds.
CHAPTER 25
PRODUCTION AND GROWTH
57
The Slope of the Supply Curve
Interest
Rate
Supply
6%
3%
60
CHAPTER 25
80
An increase in
the interest rate
makes saving
more attractive,
which increases
the quantity of
loanable funds
supplied.
Loanable Funds
($billions)
PRODUCTION AND GROWTH
58
The Market for Loanable Funds
The demand for loanable funds comes from
investment:
• Firms borrow the funds they need to pay for
new equipment, factories, etc.
• Households borrow the funds they need to
purchase new houses.
CHAPTER 25
PRODUCTION AND GROWTH
59
The Slope of the Demand Curve
A fall in the interest
rate reduces the cost
of borrowing, which
increases the quantity
of loanable funds
demanded.
Interest
Rate
7%
4%
Demand
50
80 Loanable Funds
($billions)
CHAPTER 25
PRODUCTION AND GROWTH
60
Equilibrium
Interest
Rate
Supply
The interest rate
adjusts to equate
supply and demand.
The eq’m quantity
of L.F. equals
eq’m investment
and eq’m saving.
5%
Demand
60
CHAPTER 25
Loanable Funds
($billions)
PRODUCTION AND GROWTH
61
Policy 1: Saving Incentives
Interest
Rate
S1
S2
5%
4%
D1
60 70
CHAPTER 25
Tax incentives for
saving increase
the supply of L.F.
…which reduces the
eq’m interest rate
and increases the
eq’m quantity of L.F.
Loanable Funds
($billions)
PRODUCTION AND GROWTH
62
Policy 2: Investment Incentives
Interest
Rate
An investment tax
credit increases the
demand for L.F.
S1
6%
5%
D2
…which raises the
eq’m interest rate
and increases the
eq’m quantity of L.F.
D1
60 70
CHAPTER 25
Loanable Funds
($billions)
PRODUCTION AND GROWTH
63
Policy 3: Govt Budget Deficits
Interest
Rate
S2
S1
A budget deficit reduces
national saving and the
supply of L.F.
6%
5%
D1
50 60
CHAPTER 25
…which increases
the eq’m interest rate
and decreases the
eq’m quantity of L.F.
Loanable Funds
($billions)
PRODUCTION AND GROWTH
64
ACTIVE LEARNING
Exercise
2:
Use the loanable funds model to analyze
the effects of a government budget deficit:
•
Draw the diagram showing the initial
equilibrium.
•
Determine which curve shifts when the
government runs a budget deficit.
•
•
Draw the new curve on your diagram.
What happens to the equilibrium values of the
interest rate and investment?
CHAPTER 25
PRODUCTION AND GROWTH
65
ACTIVE LEARNING
Answers
Interest
Rate
S2
S1
2:
A budget deficit reduces
national saving and the
supply of L.F.
…which increases
the eq’m interest rate
and decreases the
eq’m quantity of L.F.
and investment.
6%
5%
D1
50 60
CHAPTER 25
Loanable Funds
($billions)
PRODUCTION AND GROWTH
66
Budget Deficits, Crowding Out,
and Long-Run Growth
 Our analysis: increase in budget deficit causes
fall in investment.
The govt borrows to finance its deficit,
leaving less funds available for investment.
 This is called crowding out.
 Recall from the preceding chapter: Investment
is important for long-run economic growth.
Hence, budget deficits reduce the economy’s
growth rate and future standard of living.
CHAPTER 25
PRODUCTION AND GROWTH
67
The U.S. Government Debt
 The government finances deficits by borrowing
(selling government bonds).
 Persistent deficits lead to a rising govt debt.
 The ratio of govt debt to GDP is a useful
measure of the government’s indebtedness
relative to its ability to raise tax revenue.
 Historically, the debt-GDP ratio usually rises
during wartime and falls during peacetime – until
the early 1980s.
CHAPTER 25
PRODUCTION AND GROWTH
68
U.S. Government Debt
as a Percentage of GDP, 1970-2005
120%
WW2
100%
80%
60%
Revolutionary
War
40%
Civil
War
WW1
20%
0%
1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010
CHAPTER 25
PRODUCTION AND GROWTH
69
CONCLUSION
 Like many other markets, financial markets are
governed by the forces of supply and demand.
 One of the Ten Principles from Chapter 1:
Markets are usually a good way
to organize economic activity.
Financial markets help allocate the economy’s
scarce resources to their most efficient uses.
 Financial markets also link the present to the future:
They enable savers to convert current income into
future purchasing power, and borrowers to acquire
capital to produce goods and services in the future.
CHAPTER 25
PRODUCTION AND GROWTH
70
CHAPTER SUMMARY
 The U.S. financial system is made up of many
types of financial institutions, like the stock and
bond markets, banks, and mutual funds.
 National saving equals private saving plus
public saving.
 In a closed economy, national saving equals
investment. The financial system makes this
happen.
CHAPTER 25
PRODUCTION AND GROWTH
71
CHAPTER SUMMARY
 The supply of loanable funds comes from saving.
The demand for funds comes from investment.
The interest rate adjusts to balance supply and
demand in the loanable funds market.
 A government budget deficit is negative public
saving, so it reduces national saving, the supply of
funds available to finance investment.
 When a budget deficit crowds out investment,
it reduces the growth of productivity and GDP.
CHAPTER 25
PRODUCTION AND GROWTH
72