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Chapter 6 (Lecture Notes and Textbook Notes)

Tuesday, February 14, 2023
Birdget O’Shaughnessy
ECON 1BB3 C02

Lecture Notes (Tuesday, February 14, 2023)

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Textbook Notes (pg 148 – 173)

Introduction
 Financial markets and financial intermediaries make up financial system
 Business cycle = alternating periods of economic expansion and recission
 Expansion = total production and total employment increasing
 Recession = total production and total employment decreasing

6.1 Long-Run Economic Growth

 Process by which rising productivity increases average standard of living
 Best measure of standard of living is real GDP per person aka real GDP per capita
 Comparing performance of one economy over time or performance of different
economies at any particular time

Calculating growth rates and the rule of 70

 Small differences in growth rates can have large effects on how rapidly standard of living in
country increases
 Applies to growth in other variables

What determines rate of long-run growth

 Increases in real GDP per capita depend on increases in labour productivity
 Labour productivity = quantity of goods/services that can be produced by 1 worker or by 1 hr of
work
 Measure like this to avoid effects fluctuation sin length of workday/fraction of
population employed
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 Economists believe quantity of capital/hr worked and level of tech determine labour
productivity
1. Increases in capital/hr worked
 Workers in high-income countries have more physical capital available than workers in
low-income countries
 Capital = manufactured goods used to produce other goods/services
 Total amount of physical capital available in country is capital stock
 Increase = increase in worker productivity
 Human capital = accumulated knowledge and skills workers acquire
2. Technological change
 Come from many sources
 Technology = processes firm uses to turn inputs into outputs of goods/services
 Entrepreneurs important to operate business and bring together factors of production
to decide where to allocate resources
3. Property rights
 Govt must provide secure rights for economic growth

Potential GDP
 Level of real GDP attained when all firms producing at capacity
 Increase over time as labour force grows, new factories, new machinery/equipment, and tech
change
 Output gap = % difference b/t actual GDP and potential GDP

6.2 Saving, Investment, and the Financial System

 Retained earnings = profits reinvested in firm rather than paid to owners
 Not sufficient to finance growth
 Financial system = system of financial markets and financial intermediaries through which firms
acquire funds from households

Overview of financial system

 Financial markets = markets where financial securities are bought/sold
 Financial security = document that states terms under which funds pass from buyer to seller
 Stocks = represent partial ownership of firm
 Bonds = represent promises to repay fixed amount in future
 Financial intermediaries = firms that borrow funds from savers and lend them to borrowers
 Mutual funds sell shares to savers and use funds to buy portfolio of financial securities
 Role in financial system increased over 30yrs
 Services for savers and borrowers
 Risk = chance value of financial asset change relative to what expect
 Seek steady return on savings
 Liquidity = ease w which asset can be converted into different asset
 Usually to money
 Information
 Collection and communication about borrowers and expectations about returns
on financial securities
 Incorporate info into price of financial securities
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Macroeconomics of saving and investment

 Total value of saving in economy must = total value of investment
 Relationship b/t GDP (Y) and components, consumption (C), investment (I), government
purchases (G), and net exports (NX): Y =C + I +G+ NX
 In closed economy, net exports = 0, so rewrite relationship b/t GDP and components as follows:
Y =C + I +G
 Rearrange relationship, have expression for investment in terms of other variables:
I =Y −C−G
 Private saving = to what households retain from income after purchasing goods and services (C)
and paying taxes (T)
 Households receive income by supplying factors of production to firms (Y) and transfers
from govt (TR)
 We can write the resulting relationship b/t private savings as follows:
S private =Y +TR−T −C
 Public saving = amount of tax revenue govt retains after paying for govt purchases and making
transfer payments to households: S public =T −TR−G
 Total savings in closed economy (S) = to private saving + public saving
 S=I
National saving = investment
 Balanced budget = govt spends same amount as collects in taxes
 Budget deficit = govt spends more than collects in taxes
 T > G+TR meaning public savings negative (dissaving)
 Budget surplus = govt spends less than collects in taxes
 Increase public saving
 Results in higher level of investment spending

Market for loanable funds

 Interaction of borrowers and lenders that determines market interest rate and quantity of
loanable funds exchanged

Demand and supply in loanable funds market

 Demand determined by willingness of firms to borrow money to engage in new investment
projects
 Supply determined by willingness of households to save and by extent of govt saving/dissaving

Explaining movements in saving, investment, and interest rates

 Equilibrium in market determines quantity of loanable funds that will flow from lenders to
borrowers each period
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 Determines real interest rate lenders will receive and borrowers must pay
 Increase in demand for loanable funds

 Increase in supply of loanable funds

 Effect of budget deficit on market for loanable funds

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6.3 The Business Cycle

Some basic business cycle definitions
 Cycle illustrated using movements in real GDP
 Expansion phase = production, employment, and income increasing
 Ends w business cycle peak
 Recession phase = production, employment, and income increasing decreasing
 Ends w business cycle trough

How do we know when the economy is in recession

 Statistics Canada produces stats to monitor economy
 No official beginning/ending to recession
 Agreement that recession defined as 2 consecutive quarters of negative real GDP growth

What happens during business cycle

 As economy nears end of expansion, interest rates rising, and wages rising faster than prices
 Profits of firms falling
 Toward end of expansion, both households and firms have increased debts
 Recession begin w decline in spending on capital goods
 Sales of capital goods and consumer durables declining increasing unemployment and
reducing income
 As recession continues, conditions begin to improve
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Effect of business cycle on inflation rate

 Price level measures average prices of goods/services in economy
 Inflation rate is % increase in price level from year to year
 During expansions, inflation rate increases, near end of expansion, and during recessions,
inflation rate decreases

Effect of business cycle on unemployment rate

 Recessions increase unemployment rate