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Business Cycle
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Alternating periods of economic expansion and economic recession
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Long-Run Economic Growth
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The process by which rising productivity increases the average standard of living
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Real GDP Per Capita
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The amount of production in the economy, per person, adjusted for changes in the price level (most common measurement of long-run economic growth)
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Real GDP Per Capita Formula
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(GDP/population)/price level (price index)
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Growth Rate
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(of an economic variable like real GDP or real GDP per capita) is equal to the percentage change from one year to the next
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Approximate Annual Rate of Growth
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Average of the growth rates over periods of a few years
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Growth rate (g) Formula
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Previous real GDP X (1+g)^t= current real GDP
Solve for g.
t= number of time periods between previous and current periods
Solve for g.
t= number of time periods between previous and current periods
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Rule of 70
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Helps us to determine how long it will take for an economic variable to double:
Number of years to double= (70/growth rate)
Number of years to double= (70/growth rate)
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Labor Productivity
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Increases in real GDP per capita rely on increases in labor productivity: the quantity of goods and services that can be produced by one worker or by one hour of work.
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Factors Affecting Labor Productivity Growth
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Increases in capital per hour worked and technological change
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Capital
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Manufactured goods that are used to produce other goods and services
The more capital a worker has available to use (including human capital, the accumulated knowledge and skills workers possess), the more productive he or she will be.
The more capital a worker has available to use (including human capital, the accumulated knowledge and skills workers possess), the more productive he or she will be.
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Technological Change
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Improvements in capital or methods to combine inputs into outputs (i.e. new technologies) allow workers to produce more in a given period of time.
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Potential GDP
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Level of real GDP attained when all firms are operating at capacity. Capacity here refers to "normal" hours and a "normal" sized workforce
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Potential GDP rises when
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when the labor force expands, when a nation acquires more capital stock, or when new technologies are created (growth in potential GDP in the U.S= 3.2%; that is, the potential to produce final goods and services has been growing in the U.S. at about this rate over time)
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Retained Earnings
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Reinvesting profits back into the firm
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Financial Systems
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The system of financial markets (ex. stock and bond markets) and financial intermediaries (ex. banks) through which firms acquire funds from households
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Financial Markets
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Markets where financial securities, such as stocks and bonds, are bought and sold
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Financial Security
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Document (sometimes electronic) stating the terms under which funds pass from the buyer of the security to the seller
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Stock
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A financial security representing partial ownership of a firm
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Bond
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A financial security promising to repay a fixed amount of funds. A bond essentially a loan from a household to a firm
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Financial Intermediaries
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Firms, such as banks, mutual funds, pension funds, and insurance companies, that borrow funds from savers and lend them to borrowers
Some, like mutual funds, sell shares to savers then use the funds to buy financial securities.
Some, like mutual funds, sell shares to savers then use the funds to buy financial securities.
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3 Key Services Provided by Financial Systems
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Risk sharing, Liquidity, and Information
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Risk Sharing
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By allowing investors to spread their money over many different assets, investors can reduce their risk while maintaining a high expected return on their investment
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Liquidity
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The financial system allows savers to quickly convert their investments into cash.
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Information
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The prices of financial securities represent the beliefs of other investors and financial intermediaries about the future revenue stream from holding those securities.
This aggregation of information makes funds flow to the right firms.
This aggregation of information makes funds flow to the right firms.
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Total Value of Saving in the Economy
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Must equal the total value of investment
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GDP in a Closed Economy
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For simplicity, assume a closed economy, with no exports or imports; so
Y = C + I + G
Y = C + I + G
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Expression for investment:
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I = Y - C - G
That is, investment in a closed economy is equal to income minus consumption and government purchases
That is, investment in a closed economy is equal to income minus consumption and government purchases
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Savings
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Composed of private savings (by households, SPrivate) and public savings (by the government, SPublic)
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SPrivate
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Equal to all household income that is not spent; household incomes derive from the payments for factors of production (Y) and transfer payments (TR); households spend money on consumption (C) and taxes (T). So
SPrivate = Y + TR - C - T
SPrivate = Y + TR - C - T
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Dissaving
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The government "saves" whatever it brings in but does not spend (this may be negative)
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SPublic
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T - G - TR
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Total Saving
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S = SPrivate + SPublic = Y + TR - C - T + T - G - TR
= Y - C - G
= Y - C - G
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Savings Equals
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Investment
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SPublic is zero
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When the government spends as much as it brings in; this is known as a balanced budget
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Negative and positive values for SPublic
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Known as budget deficits and budget surpluses respectively
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Single Market
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The market for loanable funds, which is a (conceptual) interaction of borrowers and lenders determining the market interest rate and the quantity of loanable funds exchanged
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Crowding Out
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Decline in private expenditures as a result of increases in government purchases
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Idealized Business Cycle
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A typical idealized path for real GDP—rising, falling, then rising again.
The phases of rising are known as expansion; the periods of falling are recessions.
We refer to the points at which the economy changes from one phase to the other as peaks or troughs.
The phases of rising are known as expansion; the periods of falling are recessions.
We refer to the points at which the economy changes from one phase to the other as peaks or troughs.
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Recession
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Two consecutive quarters of declining real GDP;
National Bureau of Economic Research-"A recession is a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade."
National Bureau of Economic Research-"A recession is a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade."
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Nondurable Goods
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Like food and clothing
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Durable Goods
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Ones that (by definition) are expected to last three or more years, are more strongly affected by recessions
ex. furniture, appliances, and automobiles
ex. furniture, appliances, and automobiles
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Inflation Rate
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Measures the change in the price level from one year to the next
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The Great Moderation
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Annual fluctuations in real GDP were typically greater before 1950 than after 1950. Economists refer to this as the Great Moderation; post-1950 pattern of long expansions and short, mild recessions
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Explaining the Great Moderation
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The increasing importance of services, The establishment of unemployment insurance, Active federal government stabilization policies, and Increased stability of the financial system
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The increasing importance of services
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Manufacturing (especially of durable goods) is more strongly affected by recessions. The economy is based more on services now, decreasing the effect of the business cycle on GDP.
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The establishment of unemployment insurance
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Before the 1930s, unemployment insurance and other government transfer programs like Social Security did not exist. These programs increase the ability of consumers to purchase goods and services during recessions.
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Active federal government stabilization policies
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Many, though not all, economists believe that active government policies to lengthen expansions and minimize the effects of recessions have had the desired effect. The debate over the role of government in this way became particularly intense during the recession of 2007-2009.
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Increased stability of the financial system
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The severity of the Great Depression of the 1930s was in part caused by instability in the financial system; similar instability exacerbated the recession of 2007-2009. Returning to macroeconomic stability will require a stable financial system.
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