Principles of Macroeconomics Professor Jeffrey Nilsen

1. Principles of MacroeconomicsProfessor Jeffrey Nilsen The Economy in the Long Run Chapters 17 - 19

3. Chapter 17Economic Growth • Higher living standards arise from scientific & technological advances that an economy can translate into benefits for the average person • Rising living standards is mainly due to greater average labor productivity (based on skills, environment, and tools)

4. Growth of Cities • http://econ.st/142YHn4

5. Nations enjoy much higher living standards than in past • Real GDP per person measures amount of goods & services available to the average person • Real GDP can measure of standards of living: its positively related to life expectancy, infant health & literacy

6. Real GDP per Person, 1870-2003 (in 2000 US Dollars)

7. Real GDP per capita 1870 - 2003 Which nation is growing fastest, 1870 – 2003 ?

8. Small Differences in Growth rates are compounded !! • GDP growth is like compound interest • Compound interest: earn interest on previous interest earnings • Return on saving 1$ for 10 years at 10% interest rate: • “Simple interest”: 10*r + $1 or 10*(0.1)+$1 = $2 • “Compound interest”: (1+r)10*$10 or (1.1)10 * $1 = $2.59

9. Why small growth rate differences matter… • In USA, • 1870 real GDP per capita $2,936 • 2003 real GDP per capita $34,875 • Annual growth rate over these 133 years due to r in equation: • (shows how important small difference in r to resulting GDP per capita)

10. Real GDP per capita growth1870 - 2003

11. GDP per capitaDecomposition • Product of 2 terms • GDP per capita grows only if there’s growth in worker ALP and/or % of population employed % of population working GDP per worker (A.L.P.) GDP per capita Qty each worker can produce Qtyavailable for avg. person to consume

12. USA:Y / POP vs Y / N, 1960 - 2006 Y/N Y/POP

13. USAN / POP, 1960 - 2006

14. Bottom Line for sustained growth • Share of population working changes due to • More women in workforce • Delayed retirement • Child labor  etc… • but share of population can’t rise above 100% (thus, NEVER source of sustained growth). • Greater GDP per capita arises primarily from greater A.L.P.

15. Average Labor Productivity - Determinants • Is the driving force workers working with greater effort?

16. Improve A.L.P. 1:Human Capital • For a given level of effort, greater education & training raise output • Like investment in physical capital, acquire human capital by investing time, energy and money • Acquire human capital if • benefits (extra salary) • outweigh costs (time, any lost salary)

17. Source: National Public Radio, Planet Money http://www.npr.org/blogs/money/2012/10/11/162370776/college-costs-more-in-america-but-the-payoff-is-bigger?sc=nl&cc=pmb-20121011

18. Improve A.L.P. 2:Physical Capital • Investment is purchase of a capital good (long-lived good used in producing other goods and services) • Individuals work more effectively with better tools, machines, factories

19. For given number of drivers, greater capital increases both output (total rides) and A.L.P. (rides/hour) • As add more capital, benefit of additional capital diminishes (diminishing returns to capital). Assign first capital to most productive uses • Productivity rises less with new capital in industrialized nations vs. developing nations

20. Improving A.L.P. 3:Technology • Applying new technologies makes workers more productive • Better transport & communication helps other industries’ productive activity • Critical source of improved productivity (and thus most important source of economic growth)

21. Improving A.L.P. 4: Entrepreneurship & Management • Entrepreneurs create new enterprises with new products & production methods • Suggested gov’t policy: stay out the way, keep taxes low with light regulation • Managers organize production, assign workers to jobs, motivate them => obvious influence on labor productivity

22. Improving A.L.P. 5:Political & Legal Environment • Best to allow individuals to work hard, save & invest wisely & produce goods desired by public • Critical: well-defined property rights (clear rules to determine who owns what resources) • Political stability also important (investment requires stable environment) • Free & open exchange of ideas advance technological diffusion & new products

23. Costs of Economic Growth • Greater capital stock (real investment) diverts resources from consumption • Cost of R & D (research & development) • Cost of obtaining human capital • Extra work

24. (Gov’t) Policies to Promote Economic Growth • Increase human capital: free education, job training, education loans • Increase saving & investment: tax code, public investment in infrastructure • Support R&D

25. There will never be a point where growth ends !! • Improve goods to be cleaner, more efficient • Reduce pollution • Avoid worst outcomes from market system • E.g. switch to energy-saving cars if high oil prices • Problems remain: global warming, destruction of rainforests. • Such problems may not be solved through markets or political processes

26. Problem 17.2 (Greying of USA) • What would be the net change in real GDP per capita from 2006 to 2052? • For 46 years after 2006: assume share of population working is at 1960 level while A.L.P. increases same as during 1960-2006

27. Problem 17.2 • 2052 population share working = 36.4% • A.L.P. growth 1960-2006: 99.5% • A.L.P. in 2052 = $88,204 * 1.995 = 175,967 • GDP/POP = ALP*sh.wking = 175,967 * .364 = 64,052 • (if same share working as 2006: 84,663

28. Problem 17.5 (Johara, go to college?) • Objective to maximize savings in bank in 5 years • If work, earn $20,000 per year • If school, • 1st 2 years, borrow $6,000 per year for books & tuition (repay loan 3 years after graduation) • Yrs 3, 4, 5 earn $38,000 per year • Living expenses $15,000 per year

29. Problem 17.5 (Johara, go to college?) • Max savings in bank in 5 years

30. Problem 17.5 (Johara, go to college?) 0% interest: Work now: 5+5+5+5+5 =25 School: -21 -21 + 23 + 23 + 23 = 27 (go to college) b. If earn 23 now: 18+18+18+18+18 = 90 (go work) c. If books 8: -23 -23 +23 +23 +23 = 23 (go work) d. 10% interest: Work imm: 7.3+6.6+6.1+5.5+5=30.5 Text specifies that take loans at end of year needed so interestaccrues at the end of subsequent year. School: -28 -25.4 +27.8 +25.3 +23 = 22.8 (answer: go to work)

31. Chapter 18: Saving & Investment (Capital Formation) • Saving vs. Wealth • National Savings • Motives for Saving • Investment (capital formation) • Saving & Investment in Equilibrium

32. Saving • Saving = Current Income – spending on current needs (consumption) • Saving rate: percentage of Current Income that is saved • Wealth (Net Worth) = Assets – Liabilities (balance sheet: A = L + NW) • Assets = anything of value one holds • Liabilities = debts owed to others • Balance sheet: the assets you hold (A) are borrowed (L) or owned (NW) • Saving (flow) adds to wealth (stock) • Wealth may also rise due to higher valuation of assets (capital gains)

33. National Savings

34. Private Saving • Private saving is total after–tax income not spent on consumption • T (total net taxes) = total taxes – transfer payments – gov’t interest payments

35. Public Saving • Public savings = amount of public sector income not spent on current needs • Government income (revenue) arises from taxes • T > G : gov’t has “surplus” • T = G : gov’t budget balanced • T < G : gov’t has budget deficit (negative public savings)

36. National Saving (by components) Taxes NOT part of SNAT since $1 of tax adds $1 to SPUB subtracts $1 from SPRIV

37. Problem 18.1 • Kamal: • A. Construct balance sheet with • Mountain bike $300 • Credit card debt $150 • Cash $200 • Rare Egyptian coin $400 • Checking account $1,200 • B. How effect his assets, liabilities & NW? • Kamal finds coin is worthless forgery • Kamal uses $150 from salary to pay credit card balance, he spends rest of salary • Kamal writes $150 from checking account to pay off credit card balance • C. Of these transactions, which involve savings?

38. Motivations to Save • Life-cycle saving: meet long term goals such as having sufficient resources to survive retirement • Precautionary saving: protect against unexpected problems • Bequest saving: “accumulate an estate to leave to heirs” (although done by the wealthy, comprises important part of overall saving)

39. Impact of Real Interest Rateon Saving • Individuals make financial investment (in e.g. bonds or stocks) hoping for good return to augment savings • Higher real rate induces people to save more • But if higher real rate makes easier to achieve saving goal, slows saving • Savings can allow families consuming less (saving more) to eventually consume more than a family with the same income

40. Problem 18.3 • Huda & Hassan, married & working. How events affect monthly savings? • A. Huda learns she’s pregnant • B. Hassan reads about possible layoffs • C. Hassan hoped to get financial help from parents to buy house, but they can’t afford it • D. Huda wants to go to law school • E. Stock market boom greatly increases value of couple’s retirement funds

41. Investment • Real investment is purchase of new capital • Source of funds: pool of savings • Firm’s investment choice depends on • Expected benefit (expected marginal product) • Expected costs (cost of using them)

42. Should Plamen buy a taxi? • Initial cost of taxi = 20,000 • Marginal costs: 17,000, comprised of: • Financing: 10% = 2,000 p.a. • Depreciation: 10% = 2,000 p.a. • Gas/maintenance = 3,000 p.a. • Foregone salary in other job = 10,000 p.a. • Marginal benefit: 15 trips/day * 300 days * 4 leva/trip = 18,000 leva • Less 10% tax = 16,200 leva Note: breaks down up-front cost into annual expenses

43. Incentive Principle • Plamen should not invest now, but may be willing to invest if: • Interest rate falls • Cheaper maintenance or gasoline • Cheaper taxi • Higher fares • Lower taxes

44. Eqbm Savings & Investment • People save more if earn higher r => Savings curve upsloping • Firms buy fewer capital goods if r higher: Investment curve downsloping • (also nterpret I curve as “demand for saving”) • Eqbm where desired saving = desired investment • At r > eqbm r, svgs exceed invt=> savers compete to supply funds to firms wanting to invest

45. Effect of technology onEqbm Savings & Investment • Better technology increases marginal product • Investment curve shifts out • New eqbm with higher r and higher Saving & Investment

46. Effect of government deficit onEqbm Savings & Investment • Greater government budget deficit: • Savings curve shifts inward (SNAT declines at each r) • New eqbm with higher r & reduced saving & investment

47. Problem 18.8Find change in r, S, I: • B. Reduced military spending moves gov’t budget from deficit to surplus • C. New machines can produce goods more quickly and with fewer defects • E. Concerns about job security raise precautionary saving

48. Chapter 19The Financial System • Goal: to allocate (i.e. channel) saving to those entities with productive uses for it • Components: • Direct Finance (stocks and bonds) • Banks (intermediaries) • Money and its creation • Commercial banks’ role • Central banks’ role

49. Financial System allocates savings to the most productive investment projects

50. Direct Finance • Large, well-known firms can raise needed funds by issuing stocks or bonds