Lecture 7: The Real Economy in the Long Run

1. Production & Growth2. Savings, Investment & the

Financial System3. The Natural Rate of

Unemployment

PRODUCTION AND PRODUCTION AND GROWTHGROWTH

The Benefits of Growth Creation of new jobs for growing

population Satisfy increasing aspirations

through the provision of more and better goods and services Contributes to social & political

stability

Productivity

Productivity is the key determinant of growth

Productivity refers to the quantity of goods and services that a worker can produce from each hour of work.

The Factors of Production

Physical capital Human capital Natural resources Technological knowledge

Physical Capital

The stock of equipment and structures that are used to produce goods and services. Tools used to build or repair

automobiles. Tools used to build homes or

buildings. Office buildings, schools, etc.

Human Capital

The knowledge and skills that workers acquire through education, training, and experience. Like physical capital, human capital

raises a nation’s ability to produce goods and services.

Inputs used in production that are provided by nature, such as land, rivers, and mineral deposits. Renewable resources include trees

and forests. Non-renewable resources include

petroleum and coal.

Natural Resources

Technological Knowledge

Technological knowledge is the understanding of the best ways to produce goods and services.

This is used to increase the value of human capital.

The Production Function

A production function describes the relationship between the quantity of inputs used in production and the quantity of output from production.

The Production Function

Y = A F(L, K, H, N) Y = quantity of outputA = available production technologyL = quantity of labourK = quantity of physical capitalH = quantity of human capitalN = quantity of natural resources

F is a function that shows how the inputs are combined.

Government Policies That Raise Productivity and Living Standards Encourage saving and investment. Establish secure property rights and

maintain political stability. Encourage education and training. Promote free trade. Promote research and development. Control population growth.

SAVING, INVESTMENT AND THE FINANCIAL SYSTEM

The Financial System

The financial system consists of institutions that help to match one person’s saving with another person’s investment.

It moves the economy’s scarce resources from savers to borrowers.

Types of Financial Institutions

in the Australian Economy Financial Markets

Stock Market Bond Market

Financial Intermediaries Banks Managed Funds

The Bond Market

A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond.

Characteristics of a Bond

Term: The length of time until maturity.

Credit Risk: The probability that the borrower will fail to pay some of the interest or principal.

Tax Treatment: The way in which the tax laws treat the interest on the bond.

In Australia interest earned on bonds is treated as any other form of income and is taxed. In the U.S. Municipal bonds are federal tax exempt.

A share is a claim to partial ownership in a firm.

The sale of stock to raise money is called equity financing. Compared to bonds, shares offer both

higher risk and potentially higher returns.

The Stock Market

Financial Intermediaries: Banks Banks take deposits from people who

want to save and make loans to people who want to borrow.

Banks pay depositors interest and charge borrowers slightly higher interest on their loans.

Banks help create a medium of exchange by allowing people to write cheques against their deposits.

Financial Intermediaries: Mutual Funds A managed fund is an institution

that sells shares to the public and uses the proceeds to buy a selection, or portfolio, of various types of stocks, bonds, or both. They allow people with small amounts

of money to easily diversify.

Other Financial Institutions Credit unions Pension funds Insurance companies Loan sharks

Saving and Investment in the National Income Accounts Recall: Y = C + I + G + NX In a closed economy:

Y = C + I + GTotal income in the economy after paying for consumption and government purchases is called national saving, or just saving. Therefore it is assumed that:

S = I

Private Saving

Private saving is the amount of income that households have left after paying their taxes and paying for their consumption.

Private saving = (Y – T – C)

Public Saving

Public saving is the amount of tax revenue that the government has left after paying for its spending.

Public saving = (T – G)

The supply of loanable funds comes from people who have ‘unspent’ income

The demand for loanable funds comes from those who wish to borrow to make investments.

The equilibrium of the supply and demand for loanable funds determines the real interest rate.

Supply and Demand for Loanable Funds

Supply and Demand for Loanable Funds

Loanable Funds(in billions of

dollars)

0

Interest Rate

5%

Supply

Demand

$1,200

Taxes and Saving Taxes on savings reduce the

incentive to save. A tax decrease increases the

incentive for households to save at any given interest rate. The supply of loanable funds curve shifts to

the right. The equilibrium interest rate decreases. The quantity demanded for loanable funds

increases.

An Increase in the Supply of Loanable Funds

Loanable Funds (in billions of dollars)

0

InterestRate

4%

5%

Supply, S1 S2

$1,200 $1,600

2. ...which reduces the equilibrium interest rate...

Demand

1. Tax incentives for saving increase the supply of loanable funds...

3. ...and raises the equilibrium quantity of loanable funds.

A Tax Credit

An investment tax credit increases the incentive to borrow. Increases the demand for loanable

funds. Shifts the demand curve to the right. Results in a higher interest rate and a

greater quantity saved.

An Increase in the Demand for Loanable Funds

Loanable Funds(in billions of

dollars)

0

InterestRate

5%

6%

$1,200 $1,400

1. An investment tax credit increases the demand for loanable funds...

2. ...whichraises the equilibrium interest rate...

3. ...and raises the equilibrium quantity of loanable funds.

Supply

Demand, D1

D2

Budget Deficits

When the government spends more than it receives in tax revenues, the short fall is called the budget deficit.

The accumulation of past budget deficits is the government debt.

Government borrowing reduces the supply of loanable funds available to finance investment by households and firms.

The Effect of a Government Budget Deficit

Loanable Funds(in billions of dollars)

0

InterestRate

$800 $1,2003. ...and reduces the equilibrium quantity of loanable funds.

S2

2. ...which raises the equilibrium interest rate...

Supply, S1

Demand

5%

6% 1. A budget deficit decreases the supply of loanable funds...

Conclusions Financial markets are like other markets

in the economy. The real interest rate is governed by the

forces of supply and demand. Financial markets coordinate borrowing

and lending, helping to allocate the economy’s scarce resources efficiently.

The Australian financial system includes financial institutions such as the bond market, the stock market, banks, and managed funds.

Conclusion

National saving equals private saving plus public saving.

A government budget deficit represents negative public saving, reducing national saving and the supply of loanable funds.

It crowds out investment and reduces growth and GDP.

THE NATURAL RATE OF THE NATURAL RATE OF UNEMPLOYMENTUNEMPLOYMENT

Categories of Unemployment

The problem of unemployment is usually divided into two categories. The natural rate of unemployment The cyclical rate of unemployment

Natural Rate of Unemployment The natural rate of unemployment

is unemployment that does not go away on its own even in the long run.

It is the amount of unemployment that the economy normally experiences.

Cyclical Unemployment

Cyclical unemployment refers to the fluctuations in unemployment around its natural rate.

It is associated with with short-term ups and downs of the business cycle.

The Australian Unemployment Rate Since 1970

0

2

4

6

8

10

12

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998

Unemployment rate Natural rate of unemployment

Explaining unemployment

Minimum-wage laws Unions Efficiency wages Job search

Minimum-Wage Laws

WE

Quantity of labour

LE0

Surplus of labour = Unemployment

labourdemand

Wage

Minimum wage

LD LS

laboursupply

Theory of Efficiency Wages

Efficiency wages are above-equilibrium wages paid by firms in order to increase worker productivity

Attempts to attract the competent worker

Raises wage level above equilibrium Can contribute to unemployment

Reasons for paying Efficiency Wages Worker Health: Better paid workers are

more productive. Worker Turnover: A higher paid worker is

less likely to look for another job. Worker Effort: Higher wages motivate

workers to put forward their best effort. Worker Quality: Higher wages attract a

better pool of workers to apply for jobs.

Unions and Collective Bargaining By acting as a cartel with ability to

strike or otherwise impose high costs on employers, unions usually achieve above equilibrium wages for their members.

The Effect of Union Bargaining Critics argue that unions cause the

allocation of labour to be inefficient and inequitable. Wages above the competitive level

reduce the quantity of labour demanded and cause unemployment.

Some workers benefit at the expense of other workers.

The Effect of Union Bargaining Advocates of unions contend that

unions are a necessary antidote to the market power of firms that hire workers.

They claim that unions are important for helping firms respond efficiently to workers’ concerns.

Job Search Unemployment

Job search is the process by which workers find appropriate jobs given their tastes and skills.

Job search unemployment results from the fact that it takes time for qualified individuals to be matched with appropriate jobs.

The Inevitability of Job Search Unemployment Search unemployment is inevitable

because the economy is always changing.

Changes in the composition of demand among industries or regions are called sectoral shifts.

It takes time for workers to search for and find jobs in new sectors.

Public Policy and Job Search Government programs can affect

the time it takes unemployed workers to find new jobs.

These programs include the following: Government-run employment agencies Public training programs Unemployment benefits

Conclusion

The unemployment rate is the percentage of people who would like to work but don’t have jobs.

Most unemployment in Australia is attributable to a few people who are unemployed for long periods of time.

Conclusion

Minimum-wage laws can create excess labour supply and cause unemployment.

The market power of unions can cause unemployment by pushing wages above the equilibrium level.

Conclusion

The payment of efficiency wage and the time involved for workers to search for suitable jobs are other reasons for unemployment.

Unemployment benefits may increase the amount of search unemployment but they reduce poverty and may increase workers’ chances of being matched with the right jobs.

Self-Test (Hakes & Parry): Chapter 9

Match all Terms & Definitions Answer questions 1-2 of the Practice

Problems Answer Short Answer questions 1, 2, 4, 7, 9 &

10 Do all True/False Questions Answer Multiple Choice Questions 1, 2, 4,

6, 8, 9, 10, 12, 13, 15, 18, 19 & 20 Make notes on the Advanced Critical

Thinking questions Check answers in guide and revise accordingly

Self-Test (Hakes & Parry): Chapter 10

Match all Terms & Definitions Answer questions 1, 2 &3 of the Practice

Problems Answer Short Answer questions

2,3,6,7,8,11,13 & 9 Do all True/False Questions Answer Multiple Choice Questions 1, 3,

4, 7, 8, 9, 11, 13, 15 & 20 Make notes on the Advanced Critical

Thinking questions Check answers in guide and revise

accordingly

Self-Test (Hakes & Parry): Chapter 11

Match all Terms & Definitions Answer questions 1-3 of the Practice

Problems Answer Short Answer questions 1, 2, 4, 5,

6, 7, 8, 10 & 11 Do all True/False Questions Answer Multiple Choice Questions 1, 2,

4, 7, 8, 9, 11, 12, 14, 17, 18 & 20 Make notes on the Advanced Critical

Thinking questions Check answers in guide and revise

accordingly

Reading This week: Text and Study Guide

Chapters 9, 10 & 11 For next lecture: Chapters 12 & 13