On to: The financial system,

economic growth, and

Things we need to
business cycles
accomplish this week:

Understand the connection between

prosperity and human welfare; review
the miracle of compounding
Understand saving and investment
(through the loanable funds market)

Including: Basic financial analysis,

which is NOT discussed in this text to
the degree it should be

Introduce some basic arithmetic of

Macro modeling (a la Keynes):

C+I+G = Y = C+S+T
1

So, yeah we do have it better than our parents, and they had it
better than theirs, etc.: long run growth in the US of A.
The best measure of our (material) standard of living is real GDP per person,
which is usually referred to as real GDP per capita.
Figure 10.1
The Growth in Real GDP
per Capita, 19002010

Measured in 2005
dollars, real GDP per
capita in the United
States grew from about
$5,600 in 1900 to
about $42,200 in 2010.
The average American
in the year 2010 could
buy nearly eight times
as many goods and
services as the
average American in
the year 1900.

Making
the

Connection

The Connection between Economic Prosperity and

Health

Some low-income countries that have begun

to experience economic growth have seen
dramatic increases in life expectancies.
In high-income countries, life expectancy at
birth is expected to rise from about 80 years
today to about 90 years by the middle of the
twenty-first century.
MyEconLab Your Turn:

Technological advances will continue to

reduce the average number of hours worked
per day and the number of years the average
person spends in the paid workforce,
increasing the proportion of leisure time
available for discretionary hoursthe hours
remaining after sleeping, eating, and bathing.

Test your understanding by doing problem 1.8 at the end of this chapter.

Small differences in growth

rates can lead to huuuuge

differences
in human
Recall (from grammar
school?) thewelfare
miracle of

compound interest linking the present value of your

bank balance (PV) to its future value (FV):
PV x (1 + i)n = FV,
Where i = the interest rate and n = the number of
years you allow your bank balance to grow
E.g., Growth of $20k over n = 10 years:
g = 1%: $20,000(1.01)10 = $22,092
g = 3%: $20,000(1.03)10 = $26,878
g = 5%: $20,000(1.05)10 = $32,578 Personal advice:
Start investing!

The same formula (with growth

rate g inserted) applies to

n = FV
growth
, income, etc.
If PV x (1of
+ g)GDP

In previous example, raising g from 1% to 3% yields an

extra $4,786, and going to 5% yields extra $10,486

The Rule of 70: the number of years it takes

for your bank balance, or GDP, to (roughly)
double is simply 70/i or 70/g:

If g = 1%, GDP doubles in 70 years

I.e., $20,000 x (1 + .01)70 = $40,135.27

If g = 3%, GDP doubles in 23.33 years

I.e., $20,000 x (1 + .03)23.33 = $39,862.56

5

So: Slow Growth Persistent

Venezuela/Argentina v. Taiwan/S.Korea
Poverty
If youd had to choose a place to live in 1969, you mightve gone with

Venezuela or Argentina. But over the next 40 years, South Korea (g=5.7%)
and Taiwan (g=5.6%) left Venezuela (g=0.1%) and Argentina (g=1.1%) in
their dust.

Making
the

Connection

What Explains Rapid Economic Growth in Botswana?

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.

Many economists believe the pro-growth policies

of Botswanas government to protect private
property, avoid political instability and corruption,
and allow press freedom and democracy are the
most important reasons for the countrys success.
MyEconLab Your Turn:

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

Next: Back to the loanable

Aside frommarket
key factors like secure
funds

property rights and technological

improvements that enhance labor
productivity, a key factor that
influences growth rates is the
stock of capital (i.e., goods used to
produce other goods) and the rate
of investment in them;
Thatll depend on interest rates,
i.e., the price in the loanable funds
market (the operation of which we
reviewed on Day 1)

The loanable funds

market, saving, and
investment The interest rate i (or the whole

array of rates that allows for

different risk classes of lending
and borrowing) is a very key price
As we said Day 1, higher i
induces us to save more and
defer some consumption to future
But i also determines how much
capital investment occurs, which
capital projects get built, and
which dont
9

Understanding interest rates

Most of us have a positive rate of

time preferencewed rather
have $X now than the same
amount later.
The intensity of our positive rate
of time preference (i.e., how
impatient we are?) will affect the
amount we have to be paid to
defer present consumption into
the future i.e., will affect interest
rates

Greater present orientation

higher i
Greater future orientation
lower i

The market for loanable funds, in which the interaction of borrowers and
lenders determines the interest rate and the quantity of credit exchanged.
Figure 10.3

Demand and Supply in the Loanable Funds Market

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.

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.

Interest rates and investment

decisions

A common problem: In making personal

or business decisions, we often need to
compare costs incurred today to benefits
that wont arrive until some date in the
future

E.g.: If I buy a new copier for $2,500 today, Ill

save $1,000 in printing costs for each of the
next 3 years (at which point the copier wears
out completely). Worth it?
Wrong way: payback period Ill get my
investment back in 2 years, so, yeah, go for
it.

The right way to evaluate

investments
Reduce all those future benefits to their

present value, and compare to present cost

Recall: If PV x (1+i)n = FV, then PV = FV/(1+i)n
With that formula, you can reduce any future
value FV to its equivalent today.

If i = 10%, then $1,000 received 3 years from now has a

PV = $1,000/(1.10)3 = $751.31
Or, of I had $751.31 today, and invested it at 10%/yr., Id
have $1,000 in 3 years -- i.e., $751.31(1.10)3 = $1,000

The interest rate is the most important price in

the world, cause it links the present and the
future, enabling good decisions across time
13

The formula for the PV of a

stream of receipts (each equal
to R) for n years
R1

R2

R3

Rn

PV = (1 + i) + (1 + i)2 + (1 + i)3 + . . . . . + (1 + i) n
And if i = 10 %, n = 3, and R = $1000 each year

$1000
$1000
$1000
PV = (1.10) + (1.10)2 + (1.10)3 = $ 2487
So DO NOT spend $2,500 today to get back the
equivalent of $2,487 over the next 3 years

The Net Present Value

(NPV) rule for
investing After youve expressed all
costs and benefits of an
investment in terms of present
day values, just invest in
those for which benefits
exceed costs, i.e., NPV > 0

If NPV < 0, thats a signal that

someone else has a highervalued use for the money
15

And note how movements in the

interest rate affect the

propensity
toif iinvest
In our example,
falls to 8%, then:

PV = $925.93 + $857.34 + $793.83 = $2577.10

At 8%, investing in this copier now yields:

NPV = Benefits Costs = $2577.10 - $2500 = $77.10

So: lower interest rates make more

investment projects desirable; higher i will do
the opposite

Go back to our Day 1 discussion of govt

borrowing that increased i and crowded out C, I
16

Credit markets,
growth,

and
the wealth
of needs to attract
To prosper,
a nation
nationsand channel it into
savings
investment projects that create
wealth (i.e., have a Net PV > 0).

Credit (loanable funds) markets do

exactly that, as profit-seekers choose
projects with highest Net PVs;
Capitalists are not the enemy of the
people!
Secure property rights are often a
necessary condition for productive
capital investments; if rights to the
gains from such investments are not

On to: Some Macro

arithmetic
Recall from our circular flow schematic of

the economy that total ouput (Y) is the sum of

spending from households (C), firms (I),
government (G), and foreigners (NX), so that
Y = C + I + G + NX
Lets leave foreigners out of this for now (so
were a closed economy); its also true that
Y = C + S + T, the amount we consume, save
(S) or pay in taxes (T)
18

Macro arithmetic (cont.)

Therefore: Y = C + I + G = C + S + T
So: I + G = S + T

In words, investment and govt spending must

equal saving and tax receipts

When govt runs a deficit, so that G > T, then

that implies I < S

I.e., theres potential crowding out of I

Maybe in short run, no damaging effect on Y, but
over time reduced I may mean lower productivity,
lower wages, lower standards of living
19

So why do we run large and

chronic
deficits?
There are Micro
reasons

(having to do with
shortsightedness problems
and special interest effects
in the political marketplace
And Macro reasons, having
to do with the business
cycles theories developed
by this guy
On to Ch. 12

20