Lecture 7: The Real Economy in the Long Run

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Lecture 7 The Real Economy in the Long Run

1. Production Growth
2. Savings, Investment the Financial System
3. The Natural Rate of Unemployment

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PRODUCTION AND GROWTH
3
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

4
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.

5
The Factors of Production

• Physical capital
• Human capital
• Natural resources
• Technological knowledge

6
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.

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Human Capital

• The knowledge and skills that workers acquire
  through education, training, and experience.
• Like physical capital, human capital raises a
  nations ability to produce goods and services.

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Natural Resources

• 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.

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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.

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The Production Function

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

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The Production Function

• Y A F(L, K, H, N)
• Y quantity of output
• A available production technology
• L quantity of labour
• K quantity of physical capital
• H quantity of human capital
• N quantity of natural resources
• F is a function that shows how the inputs are
  combined.

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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.

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SAVING, INVESTMENT AND THE FINANCIAL SYSTEM
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The Financial System

• The financial system consists of institutions
  that help to match one persons saving with
  another persons investment.
• It moves the economys scarce resources from
  savers to borrowers.

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Types of Financial Institutions in the
Australian Economy

• Financial Markets
• Stock Market
• Bond Market
• Financial Intermediaries
• Banks
• Managed Funds

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The Bond Market

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

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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.

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The Stock Market

• 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.

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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.

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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.

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Other Financial Institutions

• Credit unions
• Pension funds
• Insurance companies
• Loan sharks

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Saving and Investment in the National Income
Accounts

• Recall Y C I G NX
• In a closed economy
• Y C I G
• Total 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

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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)

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Public Saving

• Public saving is the amount of tax revenue that
  the government has left after paying for its
  spending.
• Public saving (T G)

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Supply and Demand for Loanable Funds

• 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.

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Supply and Demand for Loanable Funds
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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.

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An Increase in the Supply of Loanable Funds
Supply, S1
S2
1. Tax incentives for saving increase the supply
of loanable funds...
5
4
2. ...which reduces the equilibrium interest
rate...
Demand
1,200
1,600
Loanable Funds (in billions of dollars)
0
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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.

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An Increase in the Demand for Loanable Funds
Supply
1. An investment tax credit increases the demand
for loanable funds...
6
5
2. ...which raises the equilibrium interest
rate...
D2
Demand, D1
1,200
1,400
0
Loanable Funds (in billions of dollars)
3. ...and raises the equilibrium quantity of
loanable funds.
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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.

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The Effect of a Government Budget Deficit
S2
Supply, S1
1. A budget deficit decreases the supply of
loanable funds...
6
5
2. ...which raises the equilibrium interest
rate...
Demand
800
1,200
Loanable Funds (in billions of dollars)
0
3. ...and reduces the equilibrium quantity of
loanable funds.
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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 economys scarce
  resources efficiently.
• The Australian financial system includes
  financial institutions such as the bond market,
  the stock market, banks, and managed funds.

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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.

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THE NATURAL RATE OF UNEMPLOYMENT
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Categories of Unemployment

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

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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.

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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.

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The Australian Unemployment Rate Since 1970
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Explaining unemployment

• Minimum-wage laws
• Unions
• Efficiency wages
• Job search

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Minimum-Wage Laws
Wage
Minimum wage
WE
Quantity of labour
LE
0
LD
LS
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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

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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.

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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.

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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.

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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.

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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.

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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.

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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

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Conclusion

• The unemployment rate is the percentage of people
  who would like to work but dont have jobs.
• Most unemployment in Australia is attributable to
  a few people who are unemployed for long periods
  of time.

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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.

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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.

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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

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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

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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

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Reading

• This week Text and Study Guide Chapters 9, 10
  11
• For next lecture Chapters 12 13