Chapter 6: Economic Growth, the Financial System, and Business Cycles

Overview and Chapter Outline

This chapter explores the fundamental concepts of long-run economic growth, the role of saving and investment within the financial system, and the dynamics of the business cycle. Understanding these topics is essential for analyzing how economies expand, fluctuate, and allocate resources over time.

• Long-Run Economic Growth

• Saving, Investment, and the Financial System

• The Business Cycle

Long-Run Economic Growth

Long-run economic growth refers to the sustained increase in a country's productive capacity and average standard of living, primarily driven by rising productivity. This is distinct from short-run economic fluctuations, which are described by the business cycle.

• Definition: The process by which rising productivity increases the average standard of living over time.

• Contrast: Short-run swings (business cycles) involve alternating periods of economic expansion and recession.

• Key Measure: Real GDP per capita—the value of goods and services produced per person, adjusted for inflation.

Example: Real GDP per Capita in Canada

Measured in 2012 dollars, real GDP per capita in Canada has risen more than threefold since 1961. This means the average Canadian can buy almost three times as many goods and services in 2021 as in 1961.

Economic Prosperity and Health

Economic prosperity and health are closely linked. Wealthier nations can allocate more resources to healthcare, resulting in longer life spans and higher productivity among citizens.

• Life Expectancy: In Canada, life expectancy has increased significantly since 1960, reflecting improvements in both economic conditions and health outcomes.

• Resource Allocation: Richer countries invest more in food, sanitation, and healthcare, contributing to longer, healthier lives.

Calculating Growth Rates and the Rule of 70

Growth rates measure the percentage change in economic variables such as real GDP over time. The Rule of 70 provides a shortcut for estimating how long it takes for a variable to double.

• Annual Growth Rate Formula:

• Rule of 70:

  • Example: At a 5% growth rate, doubling takes about 14 years.

Determinants of Long-Run Growth

Long-run growth in real GDP per capita depends on increases in labor productivity, which is the amount of goods and services produced per worker or per hour worked.

• Labor Productivity: Key to higher living standards; driven by:

  • Capital per hour worked: Includes physical capital (machinery, equipment) and human capital (skills, knowledge).

  • Technological Change: Improvements in production methods and new technologies increase output per worker.

  • Entrepreneurship: Entrepreneurs innovate and improve efficiency, contributing to productivity growth.

Property Rights and Economic Growth

Secure property rights are essential for economic growth, as they encourage investment and innovation. Governments play a crucial role in enforcing property rights, regulating the financial system, providing education, and building infrastructure.

Potential GDP and the Output Gap

Potential GDP is the level of real GDP achieved when all firms operate at normal capacity. The output gap measures the difference between actual and potential GDP.

• Positive Output Gap: Actual GDP exceeds potential, indicating unsustainable resource use.

• Negative Output Gap: Actual GDP is below potential, indicating underutilized resources.

Saving, Investment, and the Financial System

The financial system facilitates long-run economic growth by enabling firms to obtain funds for expansion. It consists of financial markets and intermediaries that connect savers and borrowers.

• Financial Markets: Where securities like stocks and bonds are traded.

• Financial Intermediaries: Institutions (banks, mutual funds, insurance companies) that channel funds from savers to borrowers.

Key Services of the Financial System

• Risk Sharing: Diversification reduces risk for investors.

• Liquidity: Savers can quickly convert investments to cash.

• Information: Prices of financial securities reflect expectations about future returns.

Macroeconomics of Saving and Investment

In a closed economy (no international trade), total saving equals total investment. The national income identity is:

• Rearranged for investment:

Saving is divided into private and public saving:

• Private Saving:

• Public Saving:

• Total Saving:

• Key Result: (Total saving equals investment)

Market for Loanable Funds

The market for loanable funds aggregates all financial markets, determining the equilibrium interest rate and quantity of funds exchanged between savers and borrowers.

• Supply: Households supply loanable funds; higher interest rates encourage more saving.

• Demand: Firms demand loanable funds for investment; lower interest rates encourage more borrowing.

Shifts in the Market for Loanable Funds

Business Cycle

The business cycle describes the short-run fluctuations in real GDP, consisting of periods of expansion and recession.

• Expansion: Rising real GDP

• Recession: Falling real GDP

• Peak: Transition from expansion to recession

• Trough: Transition from recession to expansion

In Canada, a recession is generally defined as two consecutive quarters of negative real GDP growth.

Effects of the Business Cycle

• Inflation Rate: Tends to rise during expansions and fall during recessions.

• Unemployment Rate: Rises during recessions, often peaking after the recession ends.

Example Table: Effects of Business Cycle Phases

Summary

• Long-run economic growth improves living standards through increased productivity.

• The financial system enables saving and investment, which are crucial for growth.

• The business cycle causes short-run fluctuations in output, inflation, and employment.