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Economic Growth, the Financial System, and Business Cycles

CHAPTER

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CHAPTER

Learning Objectives

6.1	Long-Run Economic Growth
6.2	Saving, Investment, and the Financial System
6.3	The Business Cycle

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In 1937, Joseph-Armand Bombardier invented a snowmobile to help people navigate snowy roads in Quebec. In 1942, he founded L’Auto-Neige Bombardier Limitée and began manufacturing 12-passenger snowmobiles. Bombardier also developed a personal snowmobile, the Ski-Doo, in 1959

In 1986, Bombardier added another product line to its manufacturing business: the Canadair Regional Jet (CRJ), a 50-seat short-haul passenger aircraft. Today, the CRJ line of regional jets is the world’s most successful regional aircraft program. Bombardier now employs more than 30 300 people worldwide and produces aerospace and transportation products.

Despite having the most successful regional aircraft program in the world, Bombardier is still subject to the business cycle. When global demand falls, demand for Bombardier’s products falls as well. On September 21, 2011, Bombardier announced that it would slow production of regional jets due to a decrease in new orders.

AN INSIDE LOOK on page 168 discusses how the business cycle affected Bombardier’s production plans as the global economy recovered from a recession.

Economic Growth and the Business Cycle at Bombardier

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Do You Help the Economy More if You Spend or if You Save?

Suppose that you have received an income tax refund check from the federal government. You are not sure what to do with the money, so you ask your two roommates for advice.

One roommate tells you that if you want to help the economy, you should save all the money because a country’s economic growth depends on the amount of saving by households.

The other roommate disagrees and advises you to spend all the money because consumer spending is a major component of gross domestic product (GDP), and your spending would help increase production and create more jobs.

See if you can answer this question by the end of the chapter:

Which of your two roommates is right?

Economics in Your Life

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Business cycle Alternating periods of economic expansion and economic recession.

One determinant of economic growth is the ability of firms to expand their operations, buy additional equipment, train workers, and adopt new technologies.

To carry out these activities, firms must acquire funds from households, either directly through financial markets—such as the stock and bond markets—or indirectly through financial intermediaries—such as banks.

Financial markets and financial intermediaries together comprise the financial system.

In this chapter, we present an overview of the financial system and see how funds flow from households to firms through the market for loanable funds.

We also begin to explore two key aspects of macroeconomics: the long-run growth that has steadily raised living standards in the United States and the short-run fluctuations of the business cycle.

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Discuss the importance of long-run economic growth.

6.1 LEARNING OBJECTIVE

Long-Run Economic Growth

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LO6.1

Figure 6.1

Real GDP per Capita, 1961–2012

The best measure of the standard of living is real GDP per person, which is usually referred to as real GDP per capita.

Long-run economic growth The process by which rising productivity increases the average standard of living.

Measured in 2007 dollars, real GDP per

capita in Canada grew from about $16 000

per person in 1961 to about $47 000 per

person in 2012. The average Canadian in

2012 could buy 2.9 times as many goods and services in 2012 as the average Canadian in

1961.

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LO6.1

The Connection between Economic Prosperity and Health

Making the Connection

Your Turn: Test your understanding by doing related problem 1.2 on page 171 at the end of this chapter.

The research of Robert Fogel, winner of the

Nobel Prize in Economics, highlights the close connection between economic growth, improvements in technology, and improvements in human physiology. One important measure of health is life expectancy at birth. As the graph below shows, life expectancy since 1960 has increased. Men born in 1960 could expect to live 68.2 years, while women born in the same year could expect to live 74.2 years.

There is a similar relationship between life expectancy at birth and real GDP per capita when we compare different countries. Countries with high real GDP per capita, such as Canada, Sweden, and Switzerland also have high life expectancies. Countries with very low real GDP per capita, such as Chad, Zimbabwe, and Togo, also have very low life expectancies..

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LO6.1

Calculating Growth Rates and the Rule of 70

The growth rate of real GDP during a particular year is equal to the percentage change from the previous year. Real GDP equaled $1 598 760 million in 2007 and rose to $1 644 639 million in 2012, so the growth of real GDP in 2012 was:

For longer periods of time, we can use the average annual growth rate. By averaging the growth rate for each year, we get approximately the same answer for shorter periods of time.

For example, real GDP in the Canada shrank by 0.2 percent in 2008 and by 2 percent in 2009, and grew by 2.9 percent in 2010. So, the average annual growth rate of real GDP for the period 2008–2010 was:

One easy way to calculate approximately how many years it will take real GDP per capita to double is to use the rule of 70, the formula for which is:

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LO6.1

Capital Manufactured goods that are used to produce other goods and services.

Increases in Capital per Hour Worked

Technological Change Economic growth depends more on technological change—an increase in the quantity of output firms can produce, using a given quantity of inputs—than on increases in capital per hour worked.

Technology refers to the processes a firm uses to turn inputs into outputs of goods and services.

In implementing technological change, entrepreneurs are of crucial importance, as is the government in providing secure rights to private property.

What Determines the Rate of Long-Run Growth?

Labour productivity The quantity of goods and services that can be produced by one worker or by one hour of work.

Increases in real GDP per capita depend on increases in labour productivity.

The total amount of physical capital available in a country is known as the country’s capital stock. As the capital stock per hour worked increases, worker productivity increases.

Increases in human capital, the accumulated knowledge and skills workers acquire from education and training or from their life experiences, are particularly important in stimulating economic growth.

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LO6.1

The Role of Technological Change in Economic Growth

Solved Problem 6.1

Between 1960 and 1995, real GDP per capita in Singapore grew at an average annual rate of 6.2 percent. This very rapid growth rate results in the level of real GDP per capita doubling about every 11.3 years. In 1995, Alwyn Young published an article in which he argued that Singapore’s growth depended more on increases in capital per hour worked, increases in the labour force participation rate, and the transfer of workers from agricultural to nonagricultural jobs than on technological change. If Young’s analysis was correct, predict what was likely to happen to Singapore’s growth rate in the years after 1995.

Solving the Problem

Step 1: Review the chapter material.

Step 2: Predict what happened to the growth rate in Singapore after 1995.

Increases in the labour force participation rate and the transfer of workers from agricultural to nonagricultural jobs are “one-shot” changes that eventually come to an end, and increases in capital per hour worked cannot sustain high rates of economic growth unless they are accompanied by technological change. We can conclude that Singapore was unlikely to sustain its high growth rates in the years after 1995. In fact, from 1996 to 2012, the growth of real GDP per capita slowed to an average rate of 3.2 percent per year, leading to a doubling of real GDP per capita only every 22 years rather than every 11.3 years.

Your Turn: For more practice, do related problem 1.6 on page 171 at the end of this chapter.

MyEconLab

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LO6.1

Many economists believe the pro-growth policies of Botswana’s government to protect private property, avoid political instability and corruption, and allow press freedom and democracy are the most important reasons for the country’s success.

Rapid Economic Growth in Botswana

Making the Connection

Your Turn: Test your understanding by doing related problem 1.14 at the end of this chapter.

MyEconLab

The graph below shows the average annual growth rate in real GDP per capita between 1960 and 2009 for the most populous sub-Saharan countries. For the Democratic Republic of Congo, data are for 1970-2004.

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LO6.1

Figure 6.2

The Output Gap

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

The Bank of Canada measures the output

gap as the difference between actual GDP

and potential GDP as a percentage of potential

GDP. When the output gap is positive, actual GDP is larger than potential GDP; when the output gap is negative, actual GDP is smaller than potential GDP. A negative output gap is associated with a recession.

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LO6.1

Discuss the role of the financial system in facilitating long-run economic growth.

6.2 LEARNING OBJECTIVE

Saving, Investment, and the Financial System

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LO6.2

An Overview of the Financial System

Financial markets Markets where financial securities, such as stocks and bonds, are bought and sold.

Financial system The system of financial markets and financial intermediaries through which firms acquire funds from households.

Firms can finance some of these activities from retained earnings, which are profits that are reinvested in the firm rather than paid to the firm’s owners.

The process of economic growth depends on the ability of firms to expand their operations, buy additional equipment, train workers, and adopt new technologies.

A financial security is a document—sometimes in electronic form—that states the terms under which funds pass from the buyer of the security—who is providing funds—to the seller.

Stocks are financial securities that represent partial ownership of a firm.

Bonds are financial securities that represent promises to repay a fixed amount of funds.

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LO6.2

Financial intermediaries Firms, such as banks, mutual funds, pension funds, and insurance companies, that borrow funds from savers and lend them to borrowers.

Mutual funds sell shares to savers and then use the funds to buy a portfolio of stocks, bonds, mortgages, and other financial securities.

The financial system provides three key services for savers and borrowers:

Risk is the chance that the value of a financial security will change relative to what you expect. The financial system provides risk sharing by allowing savers to spread their money among many financial investments.

Liquidity is the ease with which a financial security can be exchanged for money. The financial system provides the service of liquidity by providing savers with markets in which they can sell their holdings of financial securities.

The financial system provides the collection and communication of information, or facts about borrowers and expectations about returns on financial securities.

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LO6.2

The Macroeconomics of Saving and Investment

Y = C + I + G + NX

Y = C + I + G

I = Y − C − G

The total value of saving in the economy must equal the total value of investment.

To understand why, we can use some relationships from national income accounting, the methods the Bureau of Economic Analysis uses to keep track of GDP, or total production and total income in the economy.

The relationship between GDP (Y) and its components, consumption (C), investment (I), government purchases (G), and net exports (NX) is:

In an open economy, there is interaction with other economies in terms of both

trading of goods and services and borrowing and lending.

In a closed economy, there is no trading or borrowing and lending with other economies, so net exports are zero and the relationship between GDP and its components is:

If we rearrange this relationship, we have an expression for investment in terms of the other variables:

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LO6.2

Private saving (SPrivate) is equal to what households retain of their income after purchasing goods and services (C) and paying taxes (T).

Households receive income for supplying the factors of production to firms.

This portion of household income is equal to Y.

Households also receive income from government in the form of transfer payments (TR).

SPrivate = Y + TR − C − T

Public saving (SPublic) equals the amount of tax revenue the government retains after paying for government purchases and making transfer payments to households:

SPublic = T − G − TR

Total saving in the economy (S) is equal to the sum of private saving and public

saving:

S = SPrivate + SPublic

or:

S = (Y + TR − C − T) + (T − G − TR)

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LO6.2

S = I

or:

S = Y − C − G

Because the right side of this expression is identical to the expression we derived earlier for investment spending, we can conclude that total saving must equal total investment:

When the government spends the same amount that it collects in taxes, there is a balanced budget.

When the government spends more than it collects in taxes, there is a budget deficit.

In the case of a deficit, T is less than G +TR, which means that public saving is negative.

Negative saving is also known as dissaving.

When the government spends less than it collects in taxes, there is a budget surplus.

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LO6.2

Figure 6.3

The Market for Loanable Funds

The demand for loanable funds is determined by the willingness of firms to borrow money to engage in new investment projects.

The supply of loanable funds is determined by the willingness of households to save and by the extent of government saving or dissaving. Equilibrium in the market for loanable funds determines the real interest rate and the quantity of loanable funds exchanged.

Market for loanable funds The interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged.

The nominal interest rate is the stated interest rate on a loan.

The real interest rate corrects the nominal interest rate for the effect of inflation and is equal to the nominal interest rate minus the inflation rate.

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LO6.2

Explaining Movements in Saving, Investment, and Interest Rates

Figure 6.4

An Increase in the Demand for Loanable Funds

An increase in the demand for loanable funds increases the equilibrium interest rate from i1 to i2,

and it increases the equilibrium quantity of loanable funds from L1 to L2.

As a result, saving and investment both increase.

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LO6.2

Figure 6.5

An increase in the Supply of Loanable Funds

Crowding out A decline in private expenditures as a result of an increase in government purchases.

An increase in the supply of loanable funds

decreases the interest rate from i 1 to i 2 , and

it increases the equilibrium quantity of

loanable funds from L 1 to L 2 . As a result,

both saving and investment increase.

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LO6.2

Figure 6.6

The Effect of a Budget Deficit on the Market for Loanable Funds

Crowding out A decline in private expenditures as a result of an increase in government purchases.

When the government begins running a

budget deficit, the supply of loanable funds

shifts to the left. The equilibrium interest

rate increases from i 1 to i 2 , and the equilibrium

quantity of loanable funds falls from

L 1 to L 2 . As a result, saving and investment

both decline.

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LO6.2

How Does a Consumption Tax Affect Saving, Investment, the Interest Rate, and Economic Growth?

Solved Problem 6.2

Some economists and policymakers have suggested that governments should rely less on income taxes and rely more on consumption taxes (such as the GST and HST)

to generate revenue.Under the income tax, households pay taxes on all income earned.

Under a consumption tax, households pay taxes only on the income they spend.

Households would pay taxes on saved income only if they spent the money later on.

Use the market for loanable funds model to analyze the effect on saving, investment, the interest rate, and economic growth of switching from an income tax to a consumption tax.

Solving the Problem

Step 1: Review the chapter material.

Step 2: Explain the effect of switching from an income tax to a consumption tax.

Households are interested in the return they receive from saving after they have paid their taxes.

For example, consider someone who puts his savings in a certificate of deposit at an interest rate of 4 percent and whose tax rate is 25 percent.

Under an income tax, this person’s after-tax return to saving is 3 percent [4 − (4 × 0.25)].

Under a consumption tax, income that is saved is not taxed, so the return rises to 4 percent.

We can conclude that moving from an income tax to a consumption tax would increase the return to saving, causing the supply of loanable funds to increase.

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LO6.2

How Does A Consumption Tax Affect Saving, Investment, the Interest Rate, and Economic Growth?

Solved Problem 6.2

Step 3: Draw a graph of the market for loanable funds to illustrate your answer.

The supply curve for loanable funds will shift to the right as the after-tax return to saving increases under the consumption tax.

The equilibrium interest rate will fall, and the levels of saving and investment will both increase.

Because investment increases, the capital stock and the quantity of capital per hour worked will grow, and the rate of economic growth should increase.

Note that the size of the fall in the interest rate and size of the increase in loanable funds shown in the graph are larger than the effects that most economists expect would actually result from the replacement of the income tax with a consumption tax.

Your Turn: For more practice, do related problem 2.10 on page 172 at the end of this chapter.

MyEconLab

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LO6.2

Explain what happens during the business cycle.

6.3 LEARNING OBJECTIVE

The Business Cycle

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LO6.3

Some Basic Business Cycle Definitions

The fluctuations in real GDP per capita shown in Figure 10.1 reflect the underlying fluctuations in real GDP.

Dating back as long as Canada has been a country, the economy has experienced business cycles that consist of alternating periods of expanding and contracting economic activity.

During the expansion phase of the business cycle, production, employment, and income are increasing.

The period of expansion ends with a business cycle peak.

Following the business cycle peak, production, employment, and income decline as the economy enters the recession phase of the cycle.

The recession comes to an end with a business cycle trough, after which another period of expansion begins.

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LO6.3

Figure 6.7

The Business Cycle

Panel (a) shows an idealized business cycle,

with real GDP increasing smoothly in an expansion to a business cycle peak

and then decreasing smoothly in a recession to a business cycle trough,

which is followed by another expansion.

The periods of expansion are shown in green,

and the period of recession is shown in red.

Panel (b) shows the actual movements in real GDP for 2001 to 2012.

The recession that began in 2008 was a particularly deep recession.

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LO6.3

How Do We Know When the Economy Is in a Recession?

Statistics Canada does not officially decide when a recession begins or when it

ends. In Canada, there is no official beginning or end to a recession. However, elaborating on our earlier definition, there is general agreement that a recession is defined as two consecutive quarters of negative real GDP growth. That is six months of falling real GDP.

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LO6.3

The Effect of the Business Cycle on the Inflation Rate

Recall that the price level measures the average prices of goods and services in the economy and that the inflation rate is the percentage increase in the price level from one year to the next.

The inflation rate usually decreases during recessions and usually increases by the end of economic expansions.

Don’t Let This Happen to You

Don’t Confuse the Price Level and the Inflation Rate

The inflation rate is the percentage change in the price level, as measured by the consumer price index from one year to the next.

Your Turn: Test your understanding by doing related problem 3.4 on page 172 at the end of this chapter.

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LO6.3

Figure 6.8

The Effect of Recessions on the Inflation Rate

Toward the end of a typical expansion, the inflation rate begins to rise; these times are marked with blue shading. Recessions, marked by red shading, cause the inflation rate to fall. By the end of a recession, the inflation rate is below what it had been at the beginning of the recession.

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LO6.3

Figure 6.9

How Recessions Affect the Unemployment Rate

Unemployment rises during recessions and falls during expansions. The reluctance

of firms to hire new employees as well as the re-entry of discouraged workers into the labour force during the early stages of a recovery mean that the unemployment

rate usually continues to rise even after the recession has ended.

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LO6.3

Do You Help the Economy More if You Spend or if You Save?

At the beginning of the chapter, we posed a question:

Which of your two roommates is right: The one who argues that you would help the economy more by saving your tax refund check, or the one who argues that you should spend it?

In this chapter, we have seen that consumption spending promotes the production of more consumption goods and services—such as jeans and haircuts—and fewer investment goods and services—such as physical capital and worker education. Saving—and, therefore, not consuming—is necessary to fund investment expenditure.

So, saving your refund check will help the economy over the long run. But if the economy is in a recession, spending your refund check will spur more production of consumption goods.

In a sense, then, both of your roommates are correct: Spending your check will help stimulate the economy during a recession, while saving it will help the economy grow over the long run.

Economics in Your Life

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