#### Transcript Money Market - Effingham County Schools

```AP Macroeconomics
Unit 4
Unit 4 Lesson 1
 Money


I. Money

3 Functions of Money:



Medium of exchange: use it to
Unit of measure: use it to
measure worth
Store of value: use it to hold
value
I. Money

Money in Early
Societies:



Barter requires double
coincidence of wants.
Compressed tea leaves
& gold schillings are
commodity money.
valuable by gov’t
decree.
I. Money

Characteristics
of:




Portable
Durable
Divisible
Limited Supply
(to retain value)
Some islanders in Micronesia used
these carved stones called “Vai” as
currency .

Morton
I. Money




A monetary standard is a system
that makes sure currency has the
characteristics of money.
The Constitution gave the federal
gov’t the power to coin money, not
the states.
But, private banks could issue paper
money (bank notes).
This resulted in counterfeiting
problems.
Remember 4 Char.
Of \$:
-Portable
-Durable
-Divisible
-Limited Supply
I. Money

The Inconvertible Fiat Money Standard




Since 1934.
Money supply is managed by gov’t.
Tangible component: coins/bills
Intangible component: checks/bank accounts.
I. Money

Measures of the Money Supply:

M1: Currency + Checkable Deposits



Checkable deposits make up +/- 70% of M1
M2: M1 + Savings Deposits + Small Time Deposits
+ Money Market Mutual Funds + Money Mkt
Deposit Accounts
M3: M1 + M2 + large time deposits (>\$100k)
I. Money
The velocity of money (V) is the number
of times in a year that a typical dollar bill
is used to pay for a new good/service.
 V = (PY)/M, Note** V=GDP/M
 so, MV = PY
 This quantity equation relates the quantity
of money (M) to the value of output (PY).


Usually, velocity is relatively stable.
I. Money
MV = money spent
 PQ = money received by sellers

I. Money

The Federal Reserve System





Nation’s central bank.
Lends \$ to private banks.
Is set up like a corporation, but banks are
stockholders.
Privately owned, but publicly controlled.
The president appoints board of governors.
I. Money

FDIC



Federal Deposit Insurance Corporation
Insures customer deposits in event of bank
failure.
Coverage has historically been \$100,000 per
account type, per owner.
I. Money

Other Financial Institutions


Savings & Loan Association – invests majority
of its funds in home mortgages.
Credit Union – nonprofit cooperative, owned by
& operated for the benefit of its members.
II. Financial Assets & Balance
Sheets/ T-Accounts
Assets are claims on a
borrower.
 Liabilities are obligations/
things borrowed

One entity’s asset is another
entity’s liability.
 Balance sheets, or T-Accounts
must balance.

II. Financial Assets & Balance
Sheets/ T-Accounts

Banks assets include



accounts at the Federal Reserve
District Bank
Treasury securities owned by the
bank
loans to customers
Liabilities are deposits
 Net Worth=assets minus liabilities

II. Financial Assets & Balance
Sheets/ T-Accounts
Let’s start a
bank.
 We will sell
\$250k in stock.
 How should this
be entered in our
T-Account?

II. Financial Assets & Balance
Sheets/ T-Accounts
Now, we need a
building.
 We decide to build
a \$220k building
equipment.
 What does our
balance sheet look
like now?

II. Financial Assets & Balance
Sheets/ T-Accounts
For simplicity’s sake,
ignore our last balance
sheet. We’ll go back to
having \$250k cash assets
& \$250k stock liability.
 Let’s start taking deposits.
 We take in \$100k in
deposits.
 Implications for M1?
 What should we do with
this money?

II. Financial Assets & Balance
Sheets/ T-Accounts




Reserves = money in the vault
+ money deposited at the Fed
Required reserves = dollar
amount banks must have in
vault cash & Fed account.
Reserve ratio = % of deposits
banks are required to hold in
reserve.
Excess reserves = actual
reserves - required reserves
II. Financial Assets & Balance
Sheets/ T-Accounts
Clearing a check.
 One of our
customers writes a
check for \$50,000
to someone.

II. Financial Assets & Balance
Sheets/ T-Accounts
Let’s make some loans.
 This is a Fractional
Reserve Banking
System b/c reserves <
deposits.
 The Fed currently
mandates a reserve
ratio of 10%, so we can
loan out…
 ...90% of our reserves.
 We decide to loan
someone \$50k.

II. Financial Assets & Balance
Sheets/ T-Accounts
How could a bank find
itself holding less in
reserves than the
reserve ratio specifies?
 How does the bank
correct for this?


The bank borrows money
from either the Fed or
other banks.
II. Financial Assets & Balance
Sheets/ T-Accounts
What does the TAccount look like if the
loan recipient pays the
\$50k to a contractor
who deposits the \$ into
our bank?
 The bank has just
created \$50k of new
money.
 What is the most we
could loan out?

II. Financial Assets & Balance
Sheets/ T-Accounts
What does the TAccount look like if the
loan proceeds go to
another bank?
 What if the recipient
come in the next day
and pays off the loan in
full?

Hw:
 ch 16 pa 2,4,5

III. Saving & Capital Formation
Saving money makes economic growth
possible.
 One person’s savings is another person’s
loan.
 Savings make investments possible.

III. Saving & Capital Formation

PPF: consumer goods, capital goods
IV. Financial Assets & the Financial
System
Financial assets (savings accounts,
bonds…) are claims on a borrower.
 Intermediaries bring savers and borrowers
together.
 The interest a bank pays on its savings
accounts is always lower than the interest
it earns from loans.
 The difference is called the SPREAD.

IV. Financial Assets & the Financial
System
A bank pays 5% interest on its savings
account.
 The bank takes some of the money deposited
in savings accounts, & loans that money out in
the form of mortgages, car loans, consolidation
loans, etc.
 On average, the bank charges 10% on its
loans.
 What’s the spread? Why does the bank do this?

IV. Financial Assets & the Financial
System
The Money Multiplier:
 The Fractional Reserve
System allows banks to
“create” money, but
how much is created?
 Remember the
1/(1-MPC) or 1/MPS
 The money multiplier =
1/reserve requirement

IV. Financial Assets & the Financial
System
The money multiplier =
1/reserve requirement
 This gives you the
maximum size the
money supply could
reach as a result of the
deposit.
 Note the difference
between size of money
supply and the amount
of new money created.

IV. Financial Assets & the Financial
System
Leakages prevent the
money supply from
reaching levels
indicated by multiplier:
 Currency Drain-\$ that
leaves the banking
system
 Excess Reserves-Banks
don’t always loan out
all available reserves

IV. Financial Assets & the Financial
System


The money
multiplier can also
be used to
determine amount
of new loans or
multiplying initial
deposit by
multiplier, multiply
excess reserves by
multiplier.

Ch16pa 7,8,9

V. Money, the Interest Rate &
Loanable Funds

Money Demand
The value of
money is
determined by the
forces of supply
and demand.
The Quantity
Theory of Money
states that, quote,
“Mo’ money
equals...
mo’ inflation…

in the long-run.”



Value of
Money
Quantity
of
Money
V. Money, the Interest Rate &
Loanable Funds
Money Market
 The (nominal)
interest rate
balance the
supply of and
demand for
money.

Interest
Rate (i)
Quantity
of
Money
V. Money, the Interest Rate &
Loanable Funds
Loanable Funds
Market
 The real interest
bring the S & D
of loanable
funds to
equilibrium.

Real
Interest
Rate (r)
Q of
Loanable
Funds
V. Money, the Interest Rate &
Loanable Funds

Lower i and/or r chiefly spurs I, which
VI. Nonbank Financial
Intermediaries
Life insurance companies invest the
 Finance companies:
 -make (usually high interest) loans to
customers
 -offer loans through businesses (boat,
furniture, & jewelry stores)

VI. Nonbank Financial
Intermediaries
Mutual funds are corporations that buy
stock in other corporations.
 Employers put \$ in pension funds that
invest in stocks & provide retirement
income.
 Real estate investment trusts borrow \$
from banks & lend to construction
companies.

VII. Basic Investment
Considerations
Low-risk investments pay low returns.
 Consistent investing can yield large
returns because of compound interest.
 Investors should avoid complex
investments they don’t understand.
 The Time Value of Money





value of money with a given interest rate over
a given time
FV = PV + (r * PV)
PV = FV / (1 + r)
Remember: r = i - π
VII. Basic Investment
Considerations
r=i-π
 What happens to r if:
 i increases & π decreases?
 i decreases & π increases?
 i increases & π increases?
 i decreases & π decreases?
 The Fisher Effect


In the long-run, an increase in Sm will result in an increase
in π and i, but r is unaffected.
VII. Basic Investment
Considerations
The Relationship Between Risk & Return
Stocks
Bonds
Stock Based Mutual Funds
Bond Based Mutual Funds
Risk
CD’s
Savings Accounts
Return
VIII. Insurance







Types:
check
Health: pays some or all of your medical
expenses
Property: compensates you for loss of property
through fire, theft, etc. as specified
Car: Liability covers damage you cause to
someone else. Full also covers damage to
Unemployment, Disability, Vacation, Dental
IX. Looking At a Budget



Variable expenses can change
(food, entertainment).
Fixed expenses-same every
mo. (water bill).
Subtract expenses &
deductions from income, to
determine what’s left over.
X. Simple vs Compound Interest
Simple interest is a flat percentage.
 If you’re paying 10% simple interest on a
\$1,000 loan, you’ll pay \$100 in interest.
 If you’re paying 10% compound interest,
you pay more.

XI. Loans
Longer time = higher
interest rate
 The minimum most
banks will loan is \$3\$5k.

XI. Loans - Continued
Interest Rates Charged

Lowest
Highest

Credit Union- Bank- Finance Co.- Credit Card- Payday Advance
XI. How Do I Get Credit?
3 criteria for credit:
 1) Income
 2) Debt
 3) Repayment History (Credit
Score/Report)
 -To build credit: take small loans & repay
them on time

XII. Financial Assets & their
Characteristics
2 Types of markets:
 Primary market: only purchaser can redeem
 Secondary market: asset can be resold to
new owner
Note: financial assets that can be bought on
the secondary market have (2nd) by them.
 Certificates of deposit: purchaser agrees to
leave \$ in the “CD” for certain period of time.
 Individual Retirement Accounts & 401(k)
Plans are tax-sheltered investment plans.

XII. Financial Assets & their
Characteristics
Stocks: claims to partial ownership of a
corporation (2nd)
 Mutual Funds: Corporations whose only
function is to invest in other corporations
(2nd)
 Money Market Deposit Account: a highbalance (min. \$1k) savings account that you
can write checks from
 Money Market Mutual Fund: mutual funds
that invest in short-term debt (2nd)

XII. Financial Assets & their
Characteristics
Corporate bonds: loans to corps. (2nd)
 Municipal bonds: issued by state/local
gov’ts, and are safe & tax-exempt (2nd).
 Savings bonds are small loans to fed.
gov’t
 Treasury bills, notes, & bonds are loans
to fed. gov’t & are the safest financial
asset (2nd).

XIII. Bond Characteristics
Ratings are based on financial health of
company.
 D (lowest) to AAA (highest)

XIII. Bond Characteristics
Term
 Credit Risk
 Tax Treatment
 Face Amount
 Issue Price
 Maturity Date
 Coupon, Yield
 \$50 (annual) interest payment on an \$800
bond = 50/800 = 6.25% yield (annual)

XIII. Bond Characteristics
The lower the price of a bond, the higher
the yield (interest earned).
 When bond yields rise, interest rates in
general rise.
 Yield = interest payment/price


Ch13pa 1
XIV. Market Efficiency
Efficient Market Hypothesis: it’s not
possible to “beat the market” regularly
 Instead, investors should diversify (hold
many different stocks)

XV. Organized Stock Exchanges
New York Stock Exchange (NYSE): oldest
U.S. stock exchange, 2,800 corporations,
1,400 seats
 American Stock Exchange (AMEX): 750
corporations, smaller
 Smaller regional stock exchanges are
found in Boston, Memphis, Philly, etc.

XVI. The Over-the-Counter Market
Most stocks are traded electronically on
the OTC Market.
 NASDAQ is the biggest OTC market (lists
4,000 corp’s).

XVII. Measures of Stock
Performance
Dow-Jones Industrial Average is an index
of 30 stocks
 S&P 500 is an index of 500 stocks
 In a bull market, prices are rising.
 In a bear market, prices are falling.

XVIII. Short Selling
Short selling is: selling a stock…
 that you don’t own...
 but have borrowed.
 You expect P to go down.
 When it’s time to return borrowed stock…
 buy it at new P, then return it.

In the spot market, transactions are
 In the futures market, futures
contracts are bought/sold.
 Futures contracts are agreements to
buy/sell something at a certain P on a
certain day.

Options markets are markets where
stock at a certain P in the future.
 Call option gives you the right to buy
 Current Price
Price Next Week

\$45

Put option gives you the right to sell
XX. The Structure of the Fed
The Federal Reserve (Fed for short) is the
nation’s central bank.
 It’s a bank for banks.
 The Fed’s 12 district banks serve these
functions.
 The Fed and it’s district banks are quasipublic; they’re



owned by member banks
but run by appointees of the president
XX. The Structure of the Fed
The Board of Governors
supervise/regulate the Fed (7 members)
 The Fed has 12 district banks. They’re
banks for banks.
 The Federal Open Market Committee
(FOMC) controls the money supply
through sale/purchase of gov’t bonds.

XX. The Structure of the Fed








Responsibilities-The Fed:
prints money
monitors/holds bank
reserves
approves bank mergers
is gov’ts fiscal agent
clears checks
regulates money supply
is “lender of last resort”
The current reserve requirement in the U.S. is 10%
(in Rincon)
The FedAtlanta
District
Think of a dam…



A dam controls the
flow of water
downriver.
Releasing too much
water would cause
flooding.
Too little water would
cause a drought.
XXI. The Fed is like a dam...



& the river is the \$
supply.
If the gov’t releases
too much \$, this
causes inflation.
Too little \$ slows
economy & could
cause a recession.
Federal Reserve
Money Supply
XXI. Tools of Monetary Policy
Monetary policy is
increasing or
decreasing the
money supply.
 Easy money policy
stimulates the
economy but causes
inflation. (i )

XXI. Tools of Monetary Policy

Tight money policy
slows economy but
fights inflation. (i )
XXI. Tools of Monetary Policy
A bigger \$ supply causes interest rates to
fall.
 People start borrowing more so they can
get things they want now.
 This can cause GDP to rise.

XXI. Tools of
Monetary Policy


The Fed affects the
money supply by:
A) changing the
reserve requirement



affects excess
reserves
changes money
multiplier
rarely changed by Fed
XXI. Tools of Monetary Policy

B) Open Market
& selling bonds the Fed’s main tool


the Fed uses this to
target the Federal
Funds Rate: the
rate at which banks
lend money to each
other
“I Am The Fed”
XXI. Tools of Monetary Policy Continued

C) changing the
discount rate (the
rate at which the
Fed loans \$ to
banks)
To Get the Economy Going...

Bu.L.L.

So you want to run the Fed?
Extra Credit






What kind of money policy is taking place if
What does this do to interest rates?
What happens to the money supply if:
the Fed increases the reserve requirement?
the Fed sells bonds in open market
operations?
the Fed lowers the discount rate?
XXI. Tools of Monetary Policy


Q: How does the Fed stimulate the economy?
A: BLL
XXI. Tools of Monetary Policy
Cyclical Asymmetry: tight money policy
can force GDP contraction, but easy
money policy won’t necessarily result in
expansion.
 The Politics of Interest Rates



The Fed is independent from gov’t, but faces
political pressure (usually to lower interest
rates)
The president affects Fed by appointing new
members when terms expire.
Fiscal vs. Monetary

Generally, monetary policy is considered
superior to fiscal policy in the following
respects:



speed
flexibility
political acceptance
Fiscal vs. Monetary
Easy Monetary goes with Expansionary
Fiscal
 Tight Monetary goes with Contractionary
Fiscal


Ch 16pa 11, 12, 13
Fun Stuff
What happens if:
 Sm falls?

XXII. Net Exports& the Economy

3 things cause Nx to change:

Relative Price Level


Exchange Rate


if π increases, X decrease, M increase
if \$ appreciates, X decrease, M increase
Relative Interest Rates

if i rises on \$, \$ appreciates, X decrease, M increase
XXIII. Aggregate Variables & the
Money Market

The money market influences Aggregate
Supply & Demand (& RGDP & π):

& vice versa:
increase causes Dm to increase too
(remember crowding-out effect).
XXIV. Establishing the Federal
Budget





Step 1: Executive formulation-president
drafts budget
Step 2: House tweaks budget and votes on it
Step 3: Senate may approve House bill or
write its own. If they draft their own, HouseSenate work out a compromise bill
Step 4: Congress sends their bill back to
President for his approval or veto
XXIV. Establishing the Federal
Budget – Continued




Don’t write this:
What happens if the President is of a
different political party than the majority of
the House or Senate?
In 1995, President Clinton and a Republican
led Congress could not come to an
agreement on a budget, forcing several
federal agencies to temporarily shut down.
Among other costs, \$800 million was
eventually paid to government employees on
furlough at the time.
XXV. Major Spending Categories
Mandatory Spending:
Social Security,
Medicare, interest on
debt, veterans’ benefits,
etc.
 Discretionary Spending:
defense, education,
justice system, NASA,
EPA, etc.

XXV. Major Spending Categories
The biggest categories of federal spending:
 1st-National Defense  4th-Income Security
 2nd-Social Security
 5th-Health
 3rd-Medicare
 6th-Net Interest

XXVI. From the Deficit to the Debt
Deficit- expenditures in excess of
revenues in 1 yr.
 Surplus- revenues in excess of
expenditures in 1 yr.
 Federal debt- grand total owed
 KNOW THE DIFFERENCE BETWEEN
DEFICIT & DEBT!

XXVI. From the Deficit to the Debt
Federal gov’t has practiced deficit
spending since 1776.
 But, deficit spending was low until WWII.
 After 1947, there were low deficits or
surpluses until the 80s.
 In the 80s, taxes were cut & defense
spending increased.

XXVI. From the Deficit to the Debt Continued
There is a “debt ceiling”.
 Congress raised it in ‘08 to \$11.3 trillion.
 When there’s a deficit, the Treasury Dept.
can:
 sell bonds (borrow)
 print money (called monetizing the debt)

How Much Does the Government
Owe?
As of Friday 3/13/09, the federal debt
was in excess of \$10.9 trillion. That’s
over \$35 thousand per capita.
XXVII. Impact of the National
Debt
2 ways the debt hurts the economy:
 More debt = more interest owed. This
causes more tax \$ to go to interest
payments.
 When gov’t borrows, interest rates rise,
which slows economic growth.

XXVII. Impact of the National Debt
50% of the national debt is owed to the Fed.
 Rest is held by individuals, corporations, states,
& foreign gov’ts.

XXVII. Impact of the National Debt

China, Japan and the UK are the biggest foreign
holders of our debt.
XXVII. Impact of the National Debt

Social Security, Medicare, & Medicaid
spending is growing faster as the
population gets older.

Under current law, around 2035
mandatory spending will exceed tax
revenue.
XXIX. Fiscal Policy

- is the gov’ts attempt to stabilize the
economy through taxing and spending.
XXIX. Fiscal Policy

Economic Impact of Taxes



Taxes affect the FOP, & how resources are
distributed.
A tax placed on a good raises production costs,
& P goes up.
Taxes encourage or discourage certain
activities.
XXIX. Fiscal Policy
A sin tax raises revenue while reducing
consumption of a socially undesirable
product.
 Taxes change our incentives to save,
invest, and work.
 The incidence of a tax is the final burden
of the tax.
 It is easier for a producer to shift the
incidence to the consumer if the demand
is inelastic.

XXIX. Fiscal Policy
This could show the effect of a tax
on prescription medicine.
This might be the effect of a tax on
candy bars.
How much of the tax did the producer absorb?
How much of the tax did the producer pass on to the consumer?
XXIX. Fiscal Policy

Criteria for Effective Taxes




Taxes should be equitable, simple, and
efficient.
Equitable = fewer loopholes
Simple = easy to understand.
Efficient = easy to administer and successful at
generating revenue.
XXIX. Fiscal Policy

Two Principles of Taxation:



The benefit principle says people should be
taxed according to the benefits they get.
But, most benefits go to those who can least
afford to pay. Also, some gov’t benefits are
hard to measure.
The ability-to-pay principle - people should be
taxed according to their ability to pay.
XXIX. Fiscal Policy

Types of Taxes



Proportional tax - same percentage regardless
of income (Social Security: 6.2% up to
87k/yr).
Progressive tax - higher percentage tax on
people with higher incomes (income tax).
Regressive tax - higher percentage on low
incomes than on high incomes (sales tax).
XXIX. Fiscal Policy



2 ways to increase real
GDP:
Supply-Side Policies
include cutting
regulations.
Demand-Side Policies
include cutting income
taxes or increasing
gov’t spending.
RGDP
RGDP
XXIX. Fiscal Policy
The crowding-out effect revisited:
 When G increases, this causes i to increase,
which results in a decrease in i-sensitive I & C.
 GDP = C + I + G
+ Nx

XXIX. Fiscal Policy
The crowding-out effect revisited:
 When G increases, this causes i to increase,
which results in a decrease in i-sensitive I & C.
 GDP = C + I + G
+ Nx

XXIX. Fiscal Policy
The crowding-out effect revisited:
 When G increases, this causes i to increase,
which results in a decrease in i-sensitive I & C.
 GDP = C + I + G
+ Nx

Extra Credit
Fiscal Policy Or Monetary Policy?
 To slow inflation, the Fed sells bonds.
 The economy has begun to recover, &
the gov’t cuts subsidies to farmers.
 The discount rate is lowered, in an
effort to stimulate the economy.
 The gov’t raises taxes back to their
pre-recession rates.

XXX. Fiscal & Monetary Policies-Uses
Of

The Fed & the federal gov’t use fiscal and
monetary policies for several reasons:




to fight inflation
to fight unemployment
to make the business cycle more stable
Fiscal & monetary policies are often used
in tandem.
XXXI. Loanable Funds Market
What makes up S?
 D?
 Why r & not i?
 Changes in G
could affect S or
D, depending on
how you look at it.
Either way, the
same thing
happens to r.

XXXI. Loanable Funds Market
What happens if
 taxes decrease?
 latest jobs report
causes producers
to expect recession
to drag on?

Money Market or Loanable Funds Market:
What’s the Difference?

Money Market:





Short term
Money Supply controlled
by Fed (perfectly inelastic)
Interest rates are nominal
Demand for money
affected by economy
Loanable Funds Market:




Long term
Quantity supplied of
loanable funds affected by
real interest rate
Interest rates are real.
Supply and Demand for
loanable funds affected by
economy:



Households save more or
less
Fed monetary policy
Demand for money
XXXII. Inflation & Unemployment





In the short run,...
what happens to π?
Unemployment?
In the short run, high π
& low U usually occur
together.
ITSR, low π & high U
usually occur together.
XXXIII. The Phillips Curve

The Phillips curve
shows the short-run
& U.

Q: How would you
show stagflation on
this Phillips curve?
XXXIII. The Phillips Curve
A: Stagflation can
be shown by
shifting the
Phillips curve to
the right.
 Changes in AS
shift the Phillips
curve.

XXXIV. The Long Run
 **In
the long-run, an economy’s
level of production depends on it’s
quantities of productive resources
(i.e. capital, labor, etc.).**




In the long-run, Real GDP will hover around full
employment.
Inflation has no effect on production in the
long-run.
Q: What does the Phillips curve look like in the
long-run?
A: It is vertical.
XXXIV. The Long Run


Short Run
Long Run
Full Employment +/- 4%
XXXIV. The Long Run
As you recall, in the
long-run, AS is
vertical.
 Q: Implications for
fiscal & monetary
policies?
 A: Economy
naturally selfcorrects, ...

The Phillips Curve
the faster inflation
will grow.
 When output grows,
unemployment falls.
 High inflation goes
hand-in-hand with
low unemployment.

The Phillips Curve
Shows the inverse
relationship
between PL and U.
 Implies that it’s
impossible to reach
FE without
inflation.
stagflation??

The Phillips Curve
We must shift the
Phillips curve to
explain
stagflation.
 Phillips Curve is
 A change in AS
shifts the curve.

The Phillips Curve
RGDP always
hovers around the
FE level of output.
 This point is
shown here as
LRAS.
 Since there is a FE
level of output, it
stands to reason
that there is a
natural rate of
unemployment.

The Phillips Curve
So, in the longrun, the Phillips
Curve is vertical.
 What could cause
the LRPC to shift?

XXXV. Economic Growth
Economic growth is best measured using
real GDP per capita
 The percent change in this figure shows us
economic growth.
 Per capita means per person.
 Real GDP per capita has grown slower
than real GDP. What does this mean?

XXXV. Economic Growth





Determinants
Quantities of the four factors of production
(especially labor and capital).
Investment in physical capital must exceed
depreciated-capital replacement levels.
Public Policy-provide incentives for capital
investment
Labor Productivity



Advances in technology (often resulting from investment in
R&D) provide more productive physical capital, which
results in higher labor productivity.
Education and training increases human capital & also labor
productivity.
Rate of productivity growth has compounding effects on
economy over time (U.S. vs Great Britain).
XXXV. Economic Growth

Over long periods of time, small
differences in rates of productivity
growth compound like interest in a
bank account and can make enormous
difference to a society’s
prosperity. Nothing contributes
more to reduction of poverty, to
increases in leisure, and to the
country’s ability to finance
education, public health,
environmental improvement, and the
arts.
XXXV. Economic Growth
does not equate
economic
growth.
 The LRAS shifts
right.

Sources of Economic Growth
(1934-1984)
Source of Growth
% of Total growth
 Increase in Quantity of labor
32
 Increase in labor productivity
68

Technology
28

Quality of capital
19

Education and training
14

Economies of scale
9

Improved resource allocation
8

XXXV. Economic Growth

Capital investment, a closer look:



Capital investment, required for economic
growth, itself requires that people save some
of their money.
But there can be too much saving. If MPS is 1,
what good is that?
Diminishing MPK (marginal product of capital)
results eventually, as capital per worker
increases.
XXXV. Economic Growth
Economic growth increases:
 standard of living.
 tax base.
 U.S. demand for imports.
 incentive for other countries to become
market economies.

XXXVI. Growth Policy
Countries benefit from foreign investment,
but poor countries really benefit from it.
Developing economies will usually benefit
from policies that encourage investment
 Education (human capital)is at least as
important as physical-capital investment
to a country’s long-run economic success.
Gov’t policies should help provide good
schools & encourage the population to

XXXVI. Growth Policy
Healthier workers are more productive.
Gov’t’s should adopt policies that increase
the health of the population.
 Protecting property rights and promoting
political stability can foster economic
growth.
 Free trade promotes economic growth.
 Policies (provision of grants, patents, etc.)
that promote R&D foster economic
growth.

XXXVI. Growth Policy

Population growth increases a country’s
supply some of the factors of production
(labor, human capital, entrepreneurship).
Gov’t policies that encourage population
growth can contribute to economic growth.
XXXVI. Economic Growth

"The Chinese use two brush strokes to
write the word 'crisis.' One brush stroke
stands for danger; the other for
opportunity. In a crisis, be aware of the
danger - but recognize the opportunity."
Speech in Indianapolis, April 12, 1959
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