PRODUCTION and
GROWTH
Mankiw, Chapter 25
Krugman, Chapter 25
Comparing Economies Across Time and Space
*Krugman
U.S. Real GDP per Capita
*Krugman
Income Around the World
*Krugman
Rule of 70
The Rule of 70 tells us that the time it takes a variable that
grows gradually over time to double is approximately 70
divided by that variable’s annual growth rate.
*Krugman
Average Annual Growth Rates of Real GDP per
Capita, 1975–2003
*Krugman
The Sources of Long-Run Growth
- Definitions:
Labor productivity
Physical capital
Human capital
Technology
*Krugman
*Productivity refers to the
amount of goods and services
produced for each hour of a
worker’s time.
*A nation’s standard of living is
determined by the productivity of
its workers
*Living standards, as measured
by real GDP per person, vary
significantly among nations
The poorest countries have
average levels of income
that have not been seen in
the United States for many
decades.
*Annual growth rates that seem small become
large when compounded for many years.
*Compounding refers to the accumulation of a
growth rate over a period of time.
Productivity plays a key role in determining living
standards for all nations in the world.
Economists often use a PRODUCTION FUNCTION to
describe the relationship between the quantity of inputs
used in production and the quantity of output from
production.
–
–
–
–
–
–
–
Y = A F(L, K, H, N)
Y = quantity of output
A = available production technology
L = quantity of labor
K = quantity of physical capital
H = quantity of human capital
N = quantity of natural resources
F( ) is a function that shows how the inputs are
combined.
A production function has constant returns to scale if, for any positive number x,
xY = A F(xL, xK, xH, xN)
That is, a doubling of all inputs causes the amount of output to double as
well.
Production functions with constant
returns to scale have an interesting
implication.
•Setting x = 1/L,
•Y/ L = A F(1, K/ L, H/ L, N/ L)
Where:
Y/L = output per worker
K/L = physical capital per worker
H/L = human capital per worker
N/L = natural resources per worker
The preceding equation says that productivity
(Y/L) depends on physical capital per worker
(K/L), human capital per worker (H/L), and
natural resources per worker (N/L), as well as the
state of technology, (A).
Accounting for Growth: The Aggregate
Production Function
The aggregate production function is a
hypothetical function that shows how productivity
(real GDP per worker) depends on the quantities of
physical capital per worker and human capital per
worker as well as the state of technology.
*Krugman
Physical Capital and Productivity
*Krugman
Average GDP Per Person grows about
2% per year.
This means Average GDP Per Person
doubles every 35 years.
Technological Progress and Productivity
Growth
*Krugman
Government Policies That Raise
Productivity and Living Standards
•Encourage saving and investment.
•Encourage investment from abroad
•Encourage education and training.
•Establish secure property rights and
maintain political stability.
•Promote free trade.
•Promote research and development
•Condition of the infrastructure.
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One way to raise
future productivity is
to invest more
current resources
in the production
of capital.
Encourage saving and investment
*As the stock of capital
The catch-up effect
rises, the extra output
refers to the property
produced from an
whereby countries that
additional unit of capital
start off poor tend to
falls; this property is called
grow more rapidly than
diminishing returns.
countries that start off
*Because of diminishing
rich.
returns, an increase in the
saving rate leads to higher
growth only for a while.
In short, a higher savings rate increases
productivity.
Encourage investment from abroad
A capital investment that is owned
and operated by a foreign entity is
called foreign direct investment.
(Ford Motor might build a car
factory in Mexico)
An investment that is financed with
foreign money but operated by
domestic residents is called foreign
portfolio investment. (An American
might buy stock in a Mexican
corporation)
In both cases, Americans provide the
resources necessary to increase the
stock of capital in Mexico.
Encourage investment from abroad
When foreigners invest in a country, they expect a return on
that investment.
When Ford’s car factory increases capital stock, it
also increases the Mexican productivity and Mexican
GDP. Ford can then take some of this additional
income back to the U.S. in the form of profit.
Remember that GDP is income earned within a
country by residents and nonresidents,
whereas GNP is income earned by residents
both at home and abroad.
Therefore, foreign investment in Mexico raises
the income of Mexicans (GNP) by less than it
raises the production in Mexico (GDP)
Encourage education and training
For a country’s long-run growth, education
is at least as important as investment in
physical capital.
*In the United States, each year of schooling
raises a person’s wage, on average, by about 10
percent.
*Thus, one way the government can enhance the
standard of living is to provide schools and
encourage the population to take advantage of
them.
An educated person might generate new
ideas about how best to produce goods
and services, which in turn, might enter
society’s pool of knowledge and provide an
external benefit to others.
Encourage education and training
EDUCATION One problem facing
is a positive poor countries is the
externality. brain drain --the
emigration of highly
educated workers to
rich countries. If human capital does
have positive
Dilemma: Wouldn’t students
externalities, then this
from poor countries want to go
brain drain makes
to U.S. or other rich countries
those people left
for education?
behind poorer than
What happens when they get
they otherwise would
there and they don’t want to
be….
go back?
Establish secure property rights and
maintain political stability
Important for the price system to
work is an economy-wide
respect for property rights….
the ability for people to exercise
authority over resources they
own. It is VERY important that In many developing countries
the government enforce
contracts are difficult to
property rights in a free
enforce, and fraud goes
market society.
unpunished. Doing business
in these countries means that
bribes and corruption are
expected. This discourages
international investment and
domestic savings.
Encourage Free Trade
Some of the poorest countries have tried to
gain economic growth by using inwardoriented policies…….aimed at raising the
living standards by avoiding interaction with
the world.
Most economists, however, prefer the use
of outward-oriented policies…. Through
the elimination of trade barriers. Using
another country’s technology and trading
your goods for theirs acts as if the
technology were in your own country.
Promote Research and Development
Technology improves our
standard of living: telephone,
microwave oven, computer,
and the automobile, all serve to
improve the quality of life we
enjoy.
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Condition of Infrastructure
Infrastructure refers to bridges, roads,
ports, power plants….the foundation
for our economy.
A power grid that frequently shuts off
electricity to homes and businesses
or drought conditions because the
dams can’t hold enough water to get
through the dry season are both
examples of poor infrastructure.
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Poor Countries Regulate Business the
Most…
*Krugman
Success, Disappointment, and Failure
*Krugman
Success, Disappointment, and Failure
East Asian economies have done many things right and
achieved very high growth rates.
In Latin America, where some important conditions are
lacking, growth has generally been disappointing.
In Africa, real GDP per capita has declined for several
decades, although there are some signs of progress now.
The convergence hypothesis fits the data only when
factors that affect growth, such as education, infrastructure,
and favorable policies and institutions, are held equal across
countries.
*Krugman
Economics in Action: Are economies converging?
*Krugman
SAVING AND
INVESTMENT IN THE
NATIONAL INCOME
ACCOUNTS
Taken from Mankiw Ch 26
Krugman Ch 26
The Savings–Investment Spending Identity
in a Closed Economy
In a closed economy: GDP = C + I + G
SPrivate = GDP + TR − T − C
SGovernment = T − TR − G
NS = SPrivate + SGovernment = (GDP + TR − T − C) + (T − TR − G)
= GDP − C − G
Hence, I = NS
Investment spending = National savings in a closed economy
*Krugman
Recall that GDP is both total income in an
economy and total expenditure on the
economy’s output of goods and
services:
Y = C + I + G + NX
Some Important Identities
• Assume a closed economy – one that
does not engage in international trade:
Y=C+I+G
Some Important Identities
• Now, subtract C and G from both sides
of the equation:
Y – C – G =I
• The left side of the equation is the total
income in the economy after paying for
consumption and government
purchases and is called national saving,
or just saving (S).
Some Important Identities
• Substituting S for Y - C - G, the
equation can be written as:
S=I
Some Important Identities
• National saving, or saving, is equal to:
S=I
S=Y–C–G
S = (Y – T – C) + (T – G)
The Meaning of Saving and
Investment
• National Saving
– National saving is the total income in the
economy that remains after paying for
consumption and government purchases.
• Private Saving
– Private saving is the amount of income that
households have left after paying their
taxes and paying for their consumption.
Private saving = (Y – T – C)
The Meaning of Saving and
Investment
• Public Saving
– Public saving is the amount of tax revenue
that the government has left after paying
for its spending.
Public saving = (T – G)
The Meaning of Saving and
Investment
• Surplus and Deficit
– If T > G, the government runs a budget
surplus because it receives more money
than it spends.
– The surplus of T - G represents public
saving.
– If G > T, the government runs a budget
deficit because it spends more money than
it receives in tax revenue.
The Meaning of Saving and
Investment
• For the economy as a whole, saving
must be equal to investment.
S=I
Budget Surplus and Budget Deficit
*Krugman
The Savings–Investment Spending Identity
in an Open Economy
I = SPrivate + SGovernment + (IM – X) = NS + KI (10)
Investment spending = National savings + Capital
inflow in an open economy
*Krugman
The Savings-Investment Spending Identity in
Open Economies: the United States and
Japan 2003
*Krugman
THE MARKET FOR
LOANABLE FUNDS
• Financial markets coordinate the
economy’s saving and investment in the
market for loanable funds.
THE MARKET FOR
LOANABLE FUNDS
• The market for loanable funds is the
market in which those who want to save
supply funds and those who want to
borrow to invest demand funds.
THE MARKET FOR
LOANABLE FUNDS
• Loanable funds refers to all income that
people have chosen to save and lend
out, rather than use for their own
consumption.
Supply and Demand for Loanable
Funds
• The supply of loanable funds comes
from people who have extra income
they want to save and lend out.
• The demand for loanable funds comes
from households and firms that wish to
borrow to make investments.
Supply and Demand for Loanable
Funds
• The interest rate is the price of the loan.
• It represents the amount that borrowers
pay for loans and the amount that
lenders receive on their saving.
• The interest rate in the market for
loanable funds is the real interest rate.
Supply and Demand for Loanable
Funds
• Financial markets work much like other
markets in the economy.
– The equilibrium of the supply and demand
for loanable funds determines the real
interest rate.
Supply and Demand for Loanable
Funds
• Government Policies That Affect Saving
and Investment
– Taxes and saving
– Taxes and investment
– Government budget deficits
*Mankiw
The Demand for Loanable Funds
*Krugman
The Supply for Loanable Funds
*Krugman
The Market for Loanable Funds
Interest
Rate
Supply
5%
Demand
0
$1,200
Loanable Funds
(in billions of dollars)
*Mankiw
Copyright©2004 South-Western
Equilibrium in the Loanable Funds Market
*Krugman
Savings, Investment Spending, and
Government Policy
*Krugman
Increasing Private Savings
*Krugman
Policy 1: Saving Incentives
• Taxes on interest income substantially
reduce the future payoff from current
saving and, as a result, reduce the
incentive to save.
Policy 1: Saving Incentives
• A tax decrease increases the incentive
for households to save at any given
interest rate.
– The supply of loanable funds curve shifts
to the right.
– The equilibrium interest rate decreases.
– The quantity demanded for loanable funds
increases.
An Increase in the Supply of Loanable Funds
Interest
Rate
Supply, S1
S2
1. Tax incentives for
saving increase the
supply of loanable
funds . . .
5%
4%
2. . . . which
reduces the
equilibrium
interest rate . . .
Demand
0
$1,200
$1,600
Loanable Funds
(in billions of dollars)
3. . . . and raises the equilibrium
quantity of loanable funds.
Copyright©2004 South-Western
Policy 1: Saving Incentives
• If a change in tax law encourages
greater saving, the result will be lower
interest rates and greater investment.
Policy 2: Investment Incentives
• An investment tax credit increases the
incentive to borrow.
– Increases the demand for loanable funds.
– Shifts the demand curve to the right.
– Results in a higher interest rate and a
greater quantity saved.
Policy 2: Investment Incentives
• If a change in tax laws encourages
greater investment, the result will be
higher interest rates and greater saving.
An Increase in the Demand for Loanable Funds
Interest
Rate
Supply
1. An investment
tax credit
increases the
demand for
loanable funds . . .
6%
5%
2. . . . which
raises the
equilibrium
interest rate . . .
0
D2
Demand, D1
$1,200
$1,400
Loanable Funds
(in billions of dollars)
3. . . . and raises the equilibrium
quantity of loanable funds.
Copyright©2004 South-Western
Policy 3: Government Budget
Deficits and Surpluses
• When the government spends more
than it receives in tax revenues, the
short fall is called the budget deficit.
• The accumulation of past budget
deficits is called the government debt.
Policy 3: Government Budget
Deficits and Surpluses
• Government borrowing to finance its
budget deficit reduces the supply of
loanable funds available to finance
investment by households and firms.
• This fall in investment is referred to as
crowding out.
– The deficit borrowing crowds out private
borrowers who are trying to finance
investments.
Policy 3: Government Budget
Deficits and Surpluses
• A budget deficit decreases the supply of
loanable funds.
– Shifts the supply curve to the left.
– Increases the equilibrium interest rate.
– Reduces the equilibrium quantity of
loanable funds.
The Effect of a Government Budget Deficit
Interest
Rate
S2
Supply, S1
1. A budget deficit
decreases the
supply of loanable
funds . . .
6%
5%
2. . . . which
raises the
equilibrium
interest rate . . .
Demand
0
$800
$1,200
Loanable Funds
(in billions of dollars)
3. . . . and reduces the equilibrium
quantity of loanable funds.
Copyright©2004 South-Western
Policy 3: Government Budget
Deficits and Surpluses
• When government reduces national
saving by running a deficit, the interest
rate rises and investment falls.
Policy 3: Government Budget
Deficits and Surpluses
• A budget surplus increases the supply
of loanable funds, reduces the interest
rate, and stimulates investment.
The U.S. Government Debt
Percent
of GDP
120
World War II
100
80
60
Revolutionary
War
Civil
War
World War I
40
20
0
1790
1810
1830
1850
1870
1890
1910
1930
1950
1970
1990
2010
Copyright©2004 South-Western
The Financial System - Definitions
 Wealth
 Financial asset
 Physical asset
 Liability
 Transaction costs
 Financial risk
*Krugman
Risk-Averse Attitudes Toward Gain and Loss
*Krugman
Three Tasks of a Financial System
Reducing transaction costs
Reducing financial risk
Providing liquid assets
*Krugman
Financial Intermediaries
 Mutual funds
 Pension funds
 Life insurance companies
 Banks
Financial Fluctuations
Financial market fluctuations can be a source of
macroeconomic instability.
Are markets irrational?
Policy makers assume neither that markets always behave
rationally nor that they can outsmart them.
*Krugman
*Krugman
Summary
• The U.S. financial system is made up of financial
institutions such as the bond market, the stock
market, banks, and mutual funds.
• All these institutions act to direct the resources of
households who want to save some of their income
into the hands of households and firms who want to
borrow.
Summary
• National income accounting identities
reveal some important relationships
among macroeconomic variables.
• In particular, in a closed economy,
national saving must equal investment.
• Financial institutions attempt to match
one person’s saving with another
person’s investment.
Summary
• The interest rate is determined by the
supply and demand for loanable funds.
• The supply of loanable funds comes
from households who want to save
some of their income.
• The demand for loanable funds comes
from households and firms who want to
borrow for investment.
Summary
• National saving equals private saving plus public
saving.
• A government budget deficit represents negative
public saving and, therefore, reduces national saving
and the supply of loanable funds.
• When a government budget deficit crowds out
investment, it reduces the growth of productivity and
GDP.