ECONOMIC GROWTH, FINANCIAL SYSTEM AND THE BUSINESS CYCLE

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ECONOMIC GROWTH, FINANCIAL SYSTEM AND THE
BUSINESS CYCLE
PRINCIPLES OF MACROECONOMICS

• Dr. Fidel Gonzalez
• Department of Economics and Intl. Business
• Sam Houston State University

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We have covered GDP and Unemployment, now we are
going to move to talk about Real GDP
growth. Why? Because in the long-run the only way
to increase living standards of any country is by
having high constant rates of Real GDP
growth. Remember that real GDP measures the
production of a region using fixed prices so that
when the real GDP increases this is due to an
increase in production not in prices. In our
previous lectures we saw that production real
income. So when the real GDP increases
continuously that means that the real income of
the country is also increasing. You can see real
income as the number of goods or services
produced in the economy.
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• We are going to cover economic growth using the
  following steps
• First, we are going to look at few basic growth
  facts between countries.
• Second, we are going to show different ways to
  calculate Real GDP growth.
• Third, we are going to find a benchmark to
  compare the Real GDP growth so that we can say if
  the economy is doing well or not.
• Fourth, we are going to see that the financial
  system is essential to growth because it allows
  investment to take place.
• Fifth, we are going to talk about the
  relationship between savings and investment and
  the different type of savings.
• Sixth, we are going to define and see the
  difference between nominal and real interest
  rate.
• Sixth, we are going to show the investment and
  saving depend on the real interest rate by
  looking at the market for loanable funds. Thus,
  investment and economic growth are affected by
  the real interest rate.

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1) Basic facts about Real GDP growth
In order to see how economic growth affects the
living standard of the residents of a country,
initially we need to consider two variables real
GDP and population. Remember that
The GDP per capita tell us what is the income per
person of a country. The real GDP per capita tell
us what is the real income per person in the
country. In the slides about GDP growth, we saw
how countries with high GDP also have a higher
human development index, better health and in
general are happier. In order to analyze what has
happened to the standard of living in a country
we use the real GDP per capital
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1) Basic facts about Real GDP growth
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1) Basic facts about Real GDP growth

• From the previous graph we can see the following
• The US has one of the highest Real GDP per
  person.
• Japan and South Korea went from poor (low GDP per
  person) to rich (high Real GDP per person).
• In general, real GDP per person can increase,
  stay the same or even decrease.
• Countries of the same region follow a similar
  pattern.
• India and China have almost double their GDP per
  person in the last ten years. However, they
  started from a low level.

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2) Different ways to calculate Real GDP Growth
There are several ways to calculate the growth of
the real GDP per capita. The most common is the
obtain the percentage change between two
consecutive years.

• However, sometimes we want to talk about growth
  rates for a period of time (for example from 1984
  to 1988). There are two ways to do this
• Obtain the percentage growth year and then take
  the average of these numbers.
• The average Real GDP growth tells us what was the
  average rate of growth of the economy between
  1984 and 1988.

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2) Different ways to calculate Real GDP Growth
B) Obtain the annual constant growth rate using
the following formula
The ACGR tells you is if the initial number
grows at a annual constant rate of ACGR it will
reach the final number in t years. When
calculating growth rates over a long period of
time this will be the preferred method. We also
want to know how big is a growth rate. In order
to do this, we use the seventy rule
An economy will double the real GDP per capita if
it grows at annual average rate of 10 during 7
years, 7 during 10 years, 5 during 14 years,
etc.
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Consider the following data for the following
countries
For Korea the initial year is 1953 and for
Germany is 1970. Calculate the ACGR for Argentina
This means that the real income per person in
Argentina grew at a average constant rate of 1
per year during 50 years. The average growth for
Argentina
The real income per person in Argentina in
average by 1.34 per year.
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2) Different ways to calculate Real GDP Growth
The two growth rates tell different stories. The
ACGR tell us how much the Argentinean economy had
to increase every year for 50 years to go from
6,585 to 10,995. The other tell us what was the
average growth rate in the period. Note that if
the Argentinean economy would have grown at 1.34
per year during 50 years their GDP per person
will be higher than 10,995. In the next slide
you will see the growth rates using the ACGR for
several countries. A) South Korea and Japan have
the highest growth in real GDP. B) US and Mexico
have similar rates of growth. C) India and China
have high levels of growth compared to other
countries (except Japan and South Korea)
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(No Transcript)
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3) Potential GDP
When we look at the growth rate for different
countries, we want to know if the country the
level at which it is using its resources. That
is, we want to compare a country with his own
potential. Comparing growth rate between
countries has some limitations because countries
are very different. For example, the US is highly
developed country that grows much more slower
than China. This is due in part to the fact the
China and the US are countries with very
different levels of development The potential GDP
measures the GDP that would be attained if all
the firms are producing at capacity. Producing
at capacity is the production that can be
achieved when operating on normal hours, using
normal workforce. This is not static. When
population grows and the stock of capital
increases, also does the potential GDP. Growth in
potential GDP tell us how is the production
capacity of the economy growing under normal
circumstances. Growth in potential GDP is
estimated to be about 3.5 per year. However, the
actual GDP growth may be different. Usually the
economy fluctuates around the potential GDP, this
is called the Business Cycle.
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Potential GDP and the Business Cycle
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Financial System and Growth
The development of a healthy financial system is
important for growth. Remember that in the
economy we have the following types of agents
Household, Business, Government and
Foreigners. Households receive income from
working, part of the income is spent and the
other part is saved for future consumption. When
the income is saved the financial market
allocates the money to businesses that need it to
buy machinery, equipment, raw material, and so
on. In other words, savings are used to increase
the production of goods and services.
Households
Financial Institutions
Businesses
Machinery, Equipment
Consume
Save
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Financial System and Growth

• When the financial system is healthy then
  investment, production and real GDP increase.
• The financial sector provides
• Good allocation of savings specialized
  individuals evaluate firms, risks, manager and
  market conditions. Individual investor may not
  have the time or the skills to do this. When
  individuals can not evaluate all the conditions
  in the market they tend to save the money under
  the mattress because they do not like risk they
  can not measure.
• Moreover, financial intermediaries will allocate
  resources to the best opportunities and that
  increases efficiency.
• B) Improve liquidity firms investment are
  usually long or medium-term (building factories,
  buying expensive equipment, etc) and households
  do not like to have their money tied up in these
  kind of investments. The financial system creates
  equity and bonds that allows them to indirectly
  finance firms long-term projects but these
  instruments can be easily sold in the market if
  the household requires liquidity. With liquid
  financial instruments households can save and
  obtain cash relatively easily and the firms have
  access to the long-term money necessary for
  investment from the initial savers.

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Financial System and Growth
C) Monitor manager and corporate control the
financial intermediaries monitor firms to make
sure the money from the savers is used properly.
It would be very costly if every household that
lends money to a firm will have to monitor the
firm. D) Mobilize savings financial
intermediaries pool savings from different types
of households and give them a diversified
portfolio. Technological innovation is promoted
when there is money available to take measured
risks. E) Facilitating exchange the
transactions cost decreased with financial
intermediaries and households are willing to save
a little more.
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Macroeconomics of Savings and Investment
In Macroeconomics we are interested to see how an
economy saves and invest resources.
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Macroeconomics of Savings and Investment
Private Savings
Public Savings
Private savings is the amount saved by
households. Public savings is the amount saved by
the government
T-G public savings G-T government
budget Public Savings - Government Budget
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Nominal and Real Interest Rates
Nominal Interest Rate the interest rate paid on
savings by the borrower. For instance, when you
go to the Bank to borrow money you have to pay
say 5 interest on the money lent. If you borrow
100,000 for 1 year at a 5 interest rate. That
means you have to pay (100,000 0.05 ) 5,000 in
interests. This is the nominal interest rate.
However, we know that 5,000 dollars today are
not the same as 5,000 in the future. The main
difference is that you can buy different amount
of goods today with 5,000 than in the
future. For example imagine, that with the 5,000
dollars you were able to buy 2,000 beers (each
beer costs 2.5) in 2007 when you get the loan.
However, the next year in 2008 the price of beer
increases to 4 per beer. This means that you can
only buy 1,250 beers. You can see that the real
payment on the loan has been reduced. In 2008 you
pay 750 beers less than what you would have paid
in 2007. This is due to the increasing price of
beer. Therefore, inflation (price increases)
affects the amount actually paid on the loan not
in terms of money but in terms of how much we can
buy with that money.
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Nominal and Real Interest Rates
For this reason, we have to make a distinction
between real and nominal interest rate, similar
to the way we did it for Real and Nominal GDP.
Nominal Interest Rate (r) the interest on the
loan (this is the advertised interest rate) Real
Interest Rate (i) the interest rate after
correcting for inflation. That is, the real
interest rate measure how much is the interest
rate in terms of goods and services. Going back
to our previous example Nominal Interest Rate
5 Inflation Rate (4/2.5) -1 60 (remember
inflation is the increase in prices) Question
What is the Real Interest Rate? After one year
you will pay 100,000 (what you borrowed) plus
5,000 (the interest) Nominal Payment 100,000
5,000 Note that 5,000 100,000 x 5 Nominal
Payment 100,000 100,000 x 5 100,000 x (1
5) 105,000 Therefore, Nominal Payment
100,000 x ( 1 r) in this case
r5 Similarly, the Real Payment 100,000 x (1
i) the problem is that so far I do not know
what is the value of i. Before getting the real
interest rate, remember that when we talked about
Real and Nominal GDP we found that
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Nominal and Real Interest Rates
We are going to use the same procedure to get the
real interest rate and the real payment.
Also remember that GDP Deflator 1 Inflation
Rate That is, GDP Deflator Inflation Rate
1 Now putting all together
Simplify the previous Equation (1 i) x
(Inflation Rate 1) (1r) Inflation Rate 1
(Inflation Rate x i) i 1 r
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Nominal and Real Interest Rates
The ones cancel out Inflation Rate (Inflation
Rate x i) i r Solve for i i r - Inflation
Rate - (Inflation Rate x i) In most cases the
term (Inflation Rate x i) is close to zero, so we
are going to eliminate it and arrive to our final
VERY important expression i r Inflation
Rate In words, Real Interest Rate Nominal
Interest Rate Inflation Rate In our previous
example Real Interest Rate 5 - 60 -54 The
real interest rate is minus 54. This means that
at the end of the year you are paying 54 less in
terms of goods and services you can buy (in our
example beer). The previous example was a little
bit extreme because in most cases the real
interest rate is positive. For example is the
inflation rate is 3 and the nominal interest
rate is 7, then the real interest rate is 4.
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Market for Loanable Funds
Loanable funds are all funds that go from lenders
to borrowers. It is comprised of may markets such
as the stock market, bonds market, and so on. In
order to keep things simple we will refer to
market of loanable funds and that includes all
these markets.
The market for loanable funds is like any other
market. It has a supply and demand. Supply of
Loanable Funds The supply of loanable funds is
given by the how much households and government
save or disave. Households when they save they
are reducing their consumption today. The reason
HH save is because they want to consume in the
future, it is actually the only reason to save.
Therefore the savings decision for HH it is a
decision about how much they want to consumer
today and how much they want to consume tomorrow.

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Market for Loanable Funds
Question What determines how much HH save? This
is a complex question since there are several
effects. One important determinant of savings is
the confidence about the future. If HH feel
confident about the future and believe the
economy will be fine then they will not save as
much. In contrast, if they think that in the
future the economy will be in bad shape they may
want to save for rainy days. Another factor of
HH savings is the interest rate. When interest
rates are high the return on investment is high
and households tend to save more money. When
interest are low then the return on savings are
low and HH tend to save less. That is, HH savings
and the interest rate have a positive
relationship. We can show this in the following
graph
Real Interest Rate
Supply Loanable Funds
Loanable Funds (LF)
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Demand of Loanable Funds The demand for loanable
funds depends on how much firms want to borrow
money to undertake investment projects. For
example, if Ford company wants to build a bigger
factory they probably will borrow money and have
to pay interest rate on that. The higher the
interest rate the lower the amount of funds they
will borrow because it is more expensive.
Therefore, the demand for loanable funds have a
negative relationship with the interest rate.
Real Interest Rate
Demand Loanable Funds
Loanable Funds (LF)
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Equilibrium in the Market for Loanable
Funds Supply and Demand together determine the
equilibrium amount of loanable funds and the real
interest rate
Supply Loanable Funds
Real Interest Rate
i
Demand Loanable Funds
LF
Loanable Funds (LF)
The equilibrium quantity of loanable funds is LF
and the equilibrium real interest rate is i.
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Government Deficits and the Market for Loanable
Funds Imagine a closed economy (NX0) and the
government decides to fight a new war. This will
certainly increase the government spending since
more troops have to get paid and the cost of more
tanks, airplanes and so on. Before war T G
Balanced Budget With war T lt G Government
Deficit Question How does the market of loanable
funds is affected? Answer First, lets consider
what happens to the supply of loanable funds (or
savings) Public Saving T-G , clearly after the
war government savings decrease. It went from
zero to a negative number. Private Savings
Y-T-C, this is not affected Total Savings
Public Savings Private Savings Total Savings
decrease because Public Savings went down.
The equilibrium quantity of loanable funds is LF
and the equilibrium real interest rate is
i. Notice that Demand for Loanable Funds
investment and Supply of Loanable Funds
savings Hence, LF saving investment That
is, in equilibrium the supply for
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Government Deficits and the Market for Loanable
Funds A decrease in government savings moves the
supply for loanable funds to the left.
Real Interest Rate
Supply Loanable Funds Total Savings (after war)
Supply Loanable Funds Total Savings (before war)
i
i
Demand Loanable Funds Investment
Loanable Funds (LF)
LFIS
LFIS
At the initial equilibrium level LF I S
and the equilibrium real interest rate is
i. Notice that Demand for Loanable Funds
investment and Supply of Loanable Funds
savings Hence, LF saving investment The
final outcome is a reduction in Savings and
Investment and an increase in the real interest
rate Investment goes down, I lt I Savings goes
down, S lt I Interest Rate goes up, igti Note
that private investment (investment undertaken by
firms) goes down as a result of higher government
spending.
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Government Deficits and the Market for Loanable
Funds This is known as the Crowding-out
Effect Crowding-out effect higher government
spending reduces the total level of savings which
increases the interest rate and therefore
investment decreases. Thus, higher government
spending is bad for growth because it reduces
investment.