ME Merged

Seventh Edition
Principles of
Macroeconomics
Wojciech Gerson (1831-1901)

N. Gregory Mankiw
CHAPTER Measuring a
10 Nation’s Income
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In this chapter,
look for the answers to these questions
• What is Gross Domestic Product (GDP)?

• How is GDP related to a nation’s total income
and spending?
• What are the components of GDP?
• How is GDP corrected for inflation?
• Does GDP measure society’s well-being?
Micro vs. Macro
 Microeconomics:
The study of how individual households and
firms make decisions, interact with one another
in markets.
 Macroeconomics:
The study of the economy as a whole.
2
Income and Expenditure
 Gross Domestic Product (GDP) measures
total income of everyone in the economy.
 GDP also measures total expenditure on the
economy’s output of goods & services.
For the economy as a whole,

income equals expenditure
because every dollar a buyer spends
is a dollar of income for the seller.
3
The Circular-Flow Diagram
 a simple depiction of the macroeconomy
 illustrates GDP as spending, revenue,
factor payments, and income
 Preliminaries:
 Factors of production are inputs like labor,
land, capital, and natural resources.
 Factor payments are payments to the factors
of production (e.g., wages, rent).
4
Households:
 own the factors of production,
sell/rent them to firms for income
 buy and consume goods & services
Firms Households
Firms:
 buy/hire factors of production,
use them to produce goods
and services
 sell goods & services
5
Revenue (=GDP) Spending (=GDP)
Markets for
G&S Goods &
G&S
sold Services bought
Firms Households
Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income (=GDP)
profit (=GDP)
6
What This Diagram Omits
 The government
 collects taxes, buys g&s
 The financial system
 matches savers’ supply of funds with
borrowers’ demand for loans
 The foreign sector
 trades g&s, financial assets, and currencies
with the country’s residents
7
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.
Goods are valued at their market prices, so:

 All goods measured in the same units
(e.g., dollars in the U.S.)
 Things that don’t have a market value are
excluded, e.g., housework you do for yourself.
8
Final goods: intended for the end user

Intermediate goods: used as components
or ingredients in the production of other goods
GDP only includes final goods—they already
embody the value of the intermediate goods
used in their production.
9
GDP includes tangible goods

(like DVDs, mountain bikes, beer)
and intangible services
(dry cleaning, concerts, cell phone service).
10
GDP includes currently produced goods,

not goods produced in the past.
11
GDP measures the value of production that occurs

within a country’s borders, whether done by its own
citizens or by foreigners located there.
12
Usually a year or a quarter (3 months)
13
The Components of GDP
 Recall: GDP is total spending.
 Four components:
 Consumption (C)
 Investment (I)
 Government Purchases (G)
 Net Exports (NX)
 These components add up to GDP (denoted Y):
Y = C + I + G + NX
14
Consumption (C)
 is total spending by households on g&s.
 Note on housing costs:
 For renters,
consumption includes rent payments.
 For homeowners,
consumption includes the imputed rental value
of the house, but not the purchase price or
mortgage payments.
15
Investment (I)
 is total spending on goods that will be used in
the future to produce more goods.
 includes spending on
 capital equipment (e.g., machines, tools)
 structures (factories, office buildings, houses)
 inventories (goods produced but not yet sold)
Note: “Investment” does not

mean the purchase of financial
assets like stocks and bonds.
16
Government Purchases (G)
 is all spending on the g&s purchased by govt
at the federal, state, and local levels.
 G excludes transfer payments, such as
Social Security or unemployment insurance
benefits.
They are not purchases of g&s.
17
Net Exports (NX)
 NX = exports – imports
 Exports represent foreign spending on the
economy’s g&s.
 Imports are the portions of C, I, and G
that are spent on g&s produced abroad.
 Adding up all the components of GDP gives:
Y = C + I + G + NX
18
U.S. GDP and Its Components, 2013
billions % of GDP per capita
Y $16,912 100.0 $53,350
C 11,537 68.2 36,394
I 2,738 16.2 8,637
G 3,137 18.5 9,895
NX –500 –2.9 –1,577
19
ACTIVE LEARNING 1
GDP and its components
In each of the following cases, determine how much
GDP and each of its components is affected (if at all).
A. Debbie spends $300 to buy her husband dinner
at the finest restaurant in Boston.
B. Sarah spends $1200 on a new laptop to use in her
publishing business. The laptop was built in China.
C. Jane spends $800 on a computer to use in her
editing business. She got last year’s model on sale
for a great price from a local manufacturer.
D. General Motors builds $500 million worth of cars,
but consumers only buy $470 million worth of them.
ACTIVE LEARNING 1
Answers
A. Debbie spends $300 to buy her husband dinner
at the finest restaurant in Boston.
Consumption and GDP rise by $300.
B. Sarah spends $1200 on a new laptop to use in her

publishing business. The laptop was built in
China.
Investment rises by $1200, net exports fall
by $1200, GDP is unchanged.
ACTIVE LEARNING 1
Answers
C. Jane spends $800 on a computer to use in her
editing business. She got last year’s model on
sale for a great price from a local manufacturer.
Current GDP and investment do not change,
because the computer was built last year.
D. General Motors builds $500 million worth of cars,

but consumers only buy $470 million of them.
Consumption rises by $470 million,
inventory investment rises by $30 million,
and GDP rises by $500 million.
Real versus Nominal GDP
 Inflation can distort economic variables like GDP,
so we have two versions of GDP:
 Nominal GDP
 values output using current prices
 not corrected for inflation
 Real GDP
 values output using the prices of a base year
 is corrected for inflation
23
EXAMPLE:
Pizza Latte
year P Q P Q
2011 $10 400 $2.00 1000
2012 $11 500 $2.50 1100
2013 $12 600 $3.00 1200
Compute nominal GDP in each year:

Increase:
2011: $10 x 400 + $2 x 1000 = $6,000
37.5%
2012: $11 x 500 + $2.50 x 1100 = $8,250
30.9%
2013: $12 x 600 + $3 x 1200 = $10,800
24
EXAMPLE:
Pizza Latte
year P Q P Q
2011 $10 400 $2.00 1000
2012 $11 500 $2.50 1100
2013 $12 600 $3.00 1200
Compute real GDP in each year,

using 2011 as the base year: Increase:
2011: $10 x 400 + $2 x 1000 = $6,000
20.0%
2012: $10 x 500 + $2 x 1100 = $7,200
16.7%
2013: $10 x 600 + $2 x 1200 = $8,400
25
EXAMPLE:
Nominal Real
year GDP GDP
2011 $6000 $6000
2012 $8250 $7200
2013 $10,800 $8400
In each year,
 nominal GDP is measured using the (then)
current prices.
 real GDP is measured using constant prices from
the base year (2011 in this example).
26
EXAMPLE:
Nominal Real
year GDP GDP
2011 $6000 $6000
37.5% 20.0%
2012 $8250 $7200
30.9% 16.7%
2013 $10,800 $8400
 The change in nominal GDP reflects both prices

and quantities.
 The change in real GDP is the amount that
GDP would change if prices were constant
(i.e., if zero inflation).
Hence, real GDP is corrected for inflation.
27
Nominal and Real GDP in the U.S.,
1965–2013
$18 000
$16 000
$14 000
$12 000 Real GDP

billions
(base year
$10 000
2009)
$8 000
$6 000
Nominal
$4 000
GDP
$2 000
$0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
The GDP Deflator
 The GDP deflator is a measure of the overall
level of prices.
 Definition:
nominal GDP
GDP deflator = 100 x
real GDP
 One way to measure the economy’s inflation

rate is to compute the percentage increase in
the GDP deflator from one year to the next.
29
EXAMPLE:
Nominal Real GDP
year GDP GDP Deflator
2011 $6000 $6000 100.0
14.6%
2012 $8250 $7200 114.6
2013 $10,800 $8400 128.6 12.2%
Compute the GDP deflator in each year:
2011: 100 x (6000/6000) = 100.0

2012: 100 x (8250/7200) = 114.6
2013: 100 x (10,800/8400) = 128.6
30
ACTIVE LEARNING 2
Computing GDP
2011 (base yr) 2012 2013
P Q P Q P Q
Good A $30 900 $31 1000 $36 1050
Good B $100 192 $102 200 $100 205
Use the above data to solve these problems:

A. Compute nominal GDP in 2011.
B. Compute real GDP in 2012.
C. Compute the GDP deflator in 2013.
ACTIVE LEARNING 2
Answers
2011 (base yr) 2012 2013
P Q P Q P Q
Good A $30 900 $31 1000 $36 1050
Good B $100 192 $102 200 $100 205
A. Compute nominal GDP in 2011.
$30 x 900 + $100 x 192 = $46,200
B. Compute real GDP in 2012.

$30 x 1000 + $100 x 200 = $50,000
ACTIVE LEARNING 2
Answers
2011 (base yr) 2012 2013
P Q P Q P Q
Good A $30 900 $31 1000 $36 1050
Good B $100 192 $102 200 $100 205
C. Compute the GDP deflator in 2013.
Nom GDP = $36 x 1050 + $100 x 205 = $58,300
Real GDP = $30 x 1050 + $100 x 205 = $52,000
GDP deflator = 100 x (Nom GDP)/(Real GDP)
= 100 x ($58,300)/($52,000) = 112.1
GDP and Economic Well-Being
 Real GDP per capita is the main indicator of
the average person’s standard of living.
 But GDP is not a perfect measure of
well-being.
 Robert Kennedy issued a very eloquent
yet harsh criticism of GDP:
34
Gross Domestic Product…
“… does not allow for the health of our
children, the quality of their education,
or the joy of their play. It does not
include the beauty of our poetry or
the strength of our marriages, the
intelligence of our public debate or
the integrity of our public officials.
It measures neither our courage, nor our wisdom,
nor our devotion to our country. It measures everything,
in short, except that which makes life worthwhile, and it
can tell us everything about America except why we are
proud that we are Americans.”
- Senator Robert Kennedy, 1968
GDP Does Not Value:
 the quality of the environment
 leisure time
 non-market activity, such as the child care
a parent provides at home
 an equitable distribution of income
36
Then Why Do We Care About GDP?
 Having a large GDP enables a country to afford
better schools, a cleaner environment,
health care, etc.
 Many indicators of the quality of life are
positively correlated with GDP. For example…
37
GDP and Life Expectancy in 12 countries
90
Bangladesh China Japan

Life expectancy (years)
80 U.S.
Mexico
Brazil Germany
70 Russia
Indonesia
India
60
Pakistan
50 Nigeria
40
$0 $10 000 $20 000 $30 000 $40 000 $50 000
Real GDP per person 38
GDP and Average Schooling in 12 countries
14
Germany
Japan
12 U.S.
Average years of school
Russia
10 China
Mexico
8
Brazil
6 Indonesia
4
India
2
$0 $10 000 $20 000 $30 000 $40 000 $50 000
GDP and Water Quality in 12 countries
100%
Indonesia Germany
Satisfaction with water quality
90% Bangladesh U.S.

Japan
Brazil
(% of population)
80%
China
70%
Mexico
India
60%
Pakistan Russia
50%
Nigeria
40%
$0 $10 000 $20 000 $30 000 $40 000 $50 000
Summary
• Gross Domestic Product (GDP) measures a
country’s total income and expenditure.
• The four spending components of GDP include:
Consumption, Investment, Government
Purchases, and Net Exports.
• Nominal GDP is measured using current prices.
Real GDP is measured using the prices of a
constant base year and is corrected for inflation.
• GDP is the main indicator of a country’s
economic well-being, even though it is not
perfect.
Summary
• People face tradeoffs.
• The cost of any action is measured in terms of
foregone opportunities.
• Rational people make decisions by comparing
marginal costs and marginal benefits.
• People respond to incentives.
Summary
Summary
Seventh Edition
Principles of
Macroeconomics

N. Gregory Mankiw
CHAPTER Measuring the

11 Cost of Living
In this chapter,
• What is the Consumer Price Index (CPI)?

How is it calculated? What’s it used for?
• What are the problems with the CPI? How
serious are they?
• How does the CPI differ from the GDP deflator?
• How can we use the CPI to compare dollar
amounts from different years? Why would we
want to do this, anyway?
• How can we correct interest rates for inflation?
The Consumer Price Index (CPI)
 measures the typical consumer’s cost of living
 the basis of cost of living adjustments (COLAs)
in many contracts and in Social Security
2
How the CPI Is Calculated
1. Fix the “basket.”
The Bureau of Labor Statistics (BLS) surveys
consumers to determine what’s in the typical
consumer’s “shopping basket.”
2. Find the prices.
The BLS collects data on the prices of all the
goods in the basket.
3. Compute the basket’s cost.
Use the prices to compute the total cost of the
basket.
3
How the CPI Is Calculated
4. Choose a base year and compute the index.
The CPI in any year equals
cost of basket in current year
100 x
cost of basket in base year
5. Compute the inflation rate.

The percentage change in the CPI from the
preceding period.
Inflation CPI this year – CPI last year
= x 100%
rate CPI last year
4
EXAMPLE basket: {4 pizzas, 10 lattes}
price of price of
year cost of basket
pizza latte
2010 $10 $2.00 $10 x 4 + $2 x 10 = $60
2011 $11 $2.50 $11 x 4 + $2.5 x 10 = $69
2012 $12 $3.00 $12 x 4 + $3 x 10 = $78
Compute CPI in each year usingInflation rate:year:

2010 base
2010: 100 x ($60/$60) = 100 115 – 100
15% = x 100%
100
2011: 100 x ($69/$60) = 115
130 – 115
13% = x 100%
2012: 100 x ($78/$60) = 130 115
5
ACTIVE LEARNING 1
Calculate the CPI price price of
CPI basket: of beef chicken
{10 lbs beef, 2010 $4 $4
20 lbs chicken}
2011 $5 $5
The CPI basket cost $120
in 2010, the base year. 2012 $9 $6
A. Compute the CPI in 2011.
B. What was the CPI inflation rate from 2011–2012?
ACTIVE LEARNING 1
Answers price price of
{10 lbs beef, 2010 $4 $4
20 lbs chicken}
2011 $5 $5
in 2010, the base year. 2012 $9 $6
A. Compute the CPI in 2011:

Cost of CPI basket in 2011
= ($5 x 10) + ($5 x 20) = $150
CPI in 2011 = 100 x ($150/$120) = 125

ACTIVE LEARNING 1
Answers price price of
{10 lbs beef, 2010 $4 $4
20 lbs chicken}
2011 $5 $5
in 2010, the base year. 2012 $9 $6
B. What was the inflation rate from 2011–2012?

Cost of CPI basket in 2012
= ($9 x 10) + ($6 x 20) = $210
CPI in 2012 = 100 x ($210/$120) = 175
CPI inflation rate = (175 – 125)/125 = 40%
What’s in the CPI’s Basket?
Food and bev. 7.0%
17.0% 6.0%
Housing
7.0%
Apparel
4.0% 3.0%
Transportation
Medical care
Recreation 15.0%
Education and
communication
Other goods
and services 41.0%
9
ACTIVE LEARNING 2
Substitution bias
CPI basket:
cost of CPI
{10 lbs beef, beef chicken
basket
20 lbs chicken}
2010 $4 $4 $120
In 2010 and 2011,
2011 $5 $5 $150
households
bought CPI basket. 2012 $9 $6 $210
In 2012, households bought {5 lbs beef, 25 lbs chicken}.
A. Compute cost of the 2012 household basket.

B. Compute % increase in cost of household basket
over 2011–12, compare to CPI inflation rate.
ACTIVE LEARNING 2
Answers
CPI basket: cost of CPI
basket
20 lbs chicken}
2010 $4 $4 $120
Household
basket in 2012: 2011 $5 $5 $150
{5 lbs beef, 2012 $9 $6 $210
25 lbs chicken}
A. Compute cost of the 2012 household basket.

($9 x 5) + ($6 x 25) = $195
ACTIVE LEARNING 2
Answers
CPI basket: cost of CPI
basket
20 lbs chicken}
2010 $4 $4 $120
Household
basket in 2012: 2011 $5 $5 $150
{5 lbs beef, 2012 $9 $6 $210
25 lbs chicken}
B. Compute % increase in cost of household basket
over 2011–12, compare to CPI inflation rate.
Rate of increase: ($195 – $150)/$150 = 30%
CPI inflation rate from previous problem = 40%
Problems with the CPI:
Substitution Bias
 Over time, some prices rise faster than others.
 Consumers substitute toward goods that become
relatively cheaper, mitigating the effects of price
increases.
 The CPI misses this substitution because it uses
a fixed basket of goods.
 Thus, the CPI overstates increases in the cost of
living.
13
Introduction of New Goods
 The introduction of new goods increases variety,
allows consumers to find products that more
closely meet their needs.
 In effect, dollars become more valuable.
 The CPI misses this effect because it uses a
fixed basket of goods.
living.
14
Unmeasured Quality Change
 Improvements in the quality of goods in the
basket increase the value of each dollar.
 The BLS tries to account for quality changes
but probably misses some, as quality is hard to
measure.
living.
15
Problems with the CPI
 Each of these problems causes the CPI to
overstate cost of living increases.
 The BLS has made technical adjustments,
but the CPI probably still overstates inflation
by about 0.5 percent per year.
 This is important because Social Security
payments and many contracts have COLAs tied
to the CPI.
16
Two Measures of Inflation, 1960–2013
15
Percent change per year
10
-5
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
GDP deflator CPI
Contrasting the CPI and GDP Deflator
Imported consumer goods:
 included in CPI
 excluded from GDP deflator
Capital goods:
 excluded from CPI
 included in GDP deflator
The basket:
(if produced domestically)
 CPI uses fixed basket
 GDP deflator uses basket of
currently produced goods & services
This matters if different prices are
changing by different amounts.
18
ACTIVE LEARNING 3
CPI vs. GDP deflator
In each scenario, determine the effects on the
CPI and the GDP deflator.
A. Starbucks raises the price of Frappuccinos.
B. Caterpillar raises the price of the industrial
tractors it manufactures at its Illinois factory.
C. Armani raises the price of the Italian jeans it
sells in the U.S.
ACTIVE LEARNING 3
Answers
A. Starbucks raises the price of Frappuccinos.
The CPI and GDP deflator both rise.
B. Caterpillar raises the price of the industrial
tractors it manufactures at its Illinois factory.
The GDP deflator rises, the CPI does not.
C. Armani raises the price of the Italian jeans it
sells in the U.S.
The CPI rises, the GDP deflator does not.
Correcting Variables for Inflation:
Comparing Dollar Figures from Different Times
 Inflation makes it harder to compare dollar
amounts from different times.
 Example: the minimum wage
 $1.25 in Dec 1963
 $7.25 in Dec 2013
 Did min wage have more purchasing power in
Dec 1963 or Dec 2013?
 To compare, use CPI to convert 1963 figure into
“2013 dollars”…
21
Amount Amount Price level today

in today’s = in year T x
dollars dollars Price level in year T
 In our example,
 “year T ” is 12/1963, “today” is 12/2013
 Min wage was $1.25 in year T
 CPI = 30.9 in year T, CPI = 234.6 today
The minimum wage 234.6
in 1963 was $9.49 $9.49 = $1.25 x
30.9
in 2013 dollars.
22
 Researchers, business analysts, and policymakers
often use this technique to convert a time series of
current-dollar (nominal) figures into constant-dollar
(real) figures.
 They can then see how a variable has changed
over time after correcting for inflation.
 Example: the minimum wage…
23
The U.S. Minimum Wage in Current Dollars
and Today’s Dollars, 1960–2013
$12
2013 dollars
$10
Dollars per hour
$8
$6
$4
$2
current dollars
$0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
ACTIVE LEARNING 4
Comparing tuition increases
Tuition and Fees at U.S. Colleges and Universities
1990 2013
Private non-profit 4-year $9,340 $30,094
Public 4-year $1,908 $8,893
Public 2-year $906 $3,264

CPI 130.7 232.6
Instructions: Express the 1990 tuition figures in 2013

dollars, then compute the percentage increase in real
terms for all three types of schools. Which type
experienced the largest increase in real tuition costs?
ACTIVE LEARNING 4
Answers
1990 2013 % change
CPI 130.7 232.6 78.0%
Private non-profit 4-year
$9,340 $30,094
(current $)
Private non-profit 4-year
$16,622 $30,094 81.1%
(2010 $)
Public 4-year (current $) $1,908 $8,893
Public 4-year (2010 $) $3,396 $8,893 161.9%
Public 2-year (current $) $906 $3,264
Public 2-year (2010 $) $1,612 $3,264 102.4%

Indexation
A dollar amount is indexed for inflation

if it is automatically corrected for inflation
by law or in a contract.
For example, the increase in the CPI automatically

determines:
 the COLA in many multi-year labor contracts.
 adjustments in Social Security payments and
federal income tax brackets.
27
Real vs. Nominal Interest Rates
The nominal interest rate:
 the interest rate not corrected for inflation
 the rate of growth in the dollar value of a
deposit or debt
The real interest rate:
 corrected for inflation
 the rate of growth in the purchasing power of a
deposit or debt
Real interest rate
= (nominal interest rate) – (inflation rate)
28
Real vs. Nominal Interest Rates
Example:
 Deposit $1,000 for one year.
 Nominal interest rate is 9%.
 During that year, inflation is 3.5%.
 Real interest rate
= Nominal interest rate – Inflation
= 9.0% – 3.5% = 5.5%
 The purchasing power of the $1000 deposit
has grown 5.5%.
29
Real and Nominal Interest Rates in the U.S.,
1950–2013
15
10
(percent per year)
Interest rate
-5
-10
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Nominal Real
Summary
• The Consumer Price Index is a measure of the
cost of living. The CPI tracks the cost of the
typical consumer’s “basket” of goods & services.
• The CPI is used to make Cost of Living
Adjustments and to correct economic variables
for the effects of inflation.
• The real interest rate is corrected for inflation
and is computed by subtracting the inflation rate
from the nominal interest rate.
Seventh Edition
Principles of
Macroeconomics

N. Gregory Mankiw
CHAPTER Saving, Investment,

13 and the
Financial System
In this chapter,
• What are the main types of financial institutions

in the U.S. economy, and what is their function?
• What are the three kinds of saving?
• What’s the difference between saving and
investment?
• How does the financial system coordinate saving
and investment?
• How do govt policies affect saving, investment,
and the interest rate?
Financial Institutions
 The financial system: the group of institutions
that helps match the saving of one person with the
investment of another.
 Financial markets: institutions through which
savers can directly provide funds to borrowers.
Examples:
 The bond market.
A bond is a certificate of indebtedness.
 The stock market.
A stock is a claim to partial ownership in a firm.
2
Financial Institutions
 Financial intermediaries: institutions through
which savers can indirectly provide funds to
borrowers. Examples:
 Banks
 Mutual funds – institutions that sell shares to
the public and use the proceeds to buy
portfolios of stocks and bonds
3
Different Kinds of Saving
Private saving
= The portion of households’ income that is not
used for consumption or paying taxes
=Y–T–C
Public saving
= Tax revenue less government spending
=T–G
7
National Saving
National saving
= private saving + public saving
= (Y – T – C) + (T – G)
= Y – C – G
= the portion of national income that is not used
for consumption or government purchases
8
Saving and Investment
Recall the national income accounting identity:
Y = C + I + G + NX
For the rest of this chapter, focus on the closed
economy case:
Y=C+I+G
national saving
Solve for I:
I = Y–C–G = (Y – T – C) + (T – G)
Saving = investment in a closed economy
9
Budget Deficits and Surpluses
Budget surplus
= an excess of tax revenue over govt spending
= T–G
= public saving
Budget deficit
= a shortfall of tax revenue from govt spending
= G–T
= – (public saving)
10
ACTIVE LEARNING 1
A. Calculations
 Suppose GDP equals $10 trillion,
consumption equals $6.5 trillion,
the government spends $2 trillion
and has a budget deficit of $300 billion.
 Find public saving, taxes, private saving, national
saving, and investment.
ACTIVE LEARNING 1
Answers, part A
Given:
Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3
Public saving = T – G = – 0.3
Taxes: T = G – 0.3 = 1.7
Private saving = Y – T – C = 10 – 1.7 – 6.5 = 1.8
National saving = Y – C – G = 10 – 6.5 = 2 = 1.5
Investment = national saving = 1.5

ACTIVE LEARNING 1
B. How a tax cut affects saving
 Use the numbers from the preceding exercise,
but suppose now that the government cuts taxes by
$200 billion.
 In each of the following two scenarios,
determine what happens to public saving,
private saving, national saving, and investment.
1. Consumers save the full proceeds of the
tax cut.
2. Consumers save 1/4 of the tax cut and spend the
other 3/4.
ACTIVE LEARNING 1
Answers, part B
In both scenarios, public saving falls by
$200 billion, and the budget deficit rises
from $300 billion to $500 billion.
1. If consumers save the full $200 billion,
national saving is unchanged,
so investment is unchanged.
2. If consumers save $50 billion and spend $150
billion, then national saving and investment each
fall by $150 billion.
ACTIVE LEARNING 1
C. Discussion questions
The two scenarios from this exercise were:
1. Consumers save the full proceeds of the
tax cut.
2. Consumers save 1/4 of the tax cut and spend
the other 3/4.
 Which of these two scenarios do you think is

more realistic?
 Why is this question important?
The Meaning of Saving and Investment
 Private saving is the income remaining after
households pay their taxes and pay for
consumption.
 Examples of what households do with saving:
 Buy corporate bonds or equities
 Purchase a certificate of deposit at the bank
 Buy shares of a mutual fund
 Let accumulate in saving or checking accounts
16
The Meaning of Saving and Investment
 Investment is the purchase of new capital.
 Examples of investment:
 General Motors spends $250 million to build
a new factory in Flint, Michigan.
 You buy $5000 worth of computer equipment
for your business.
 Your parents spend $300,000 to have a new
house built.
Remember: In economics, investment is NOT
the purchase of stocks and bonds!
17
The Market for Loanable Funds
 A supply–demand model of the financial system
 Helps us understand:
 how the financial system coordinates
saving & investment.
 how govt policies and other factors affect
saving, investment, the interest rate.
18
Assume: only one financial market
 All savers deposit their saving in this market.
 All borrowers take out loans from this market.
 There is one interest rate, which is both the
return to saving and the cost of borrowing.
19
The supply of loanable funds comes from saving:
 Households with extra income can loan it out
and earn interest.
 Public saving, if positive, adds to national
saving and the supply of loanable funds.
If negative, it reduces national saving and the
supply of loanable funds.
20
The Slope of the Supply Curve
An increase in
Interest
Rate Supply
the interest rate
makes saving
more attractive,
6%
which increases
the quantity of
loanable funds
3% supplied.
60 80 Loanable Funds
($billions)
21
The demand for loanable funds comes from
investment:
 Firms borrow the funds they need to pay for
new equipment, factories, etc.
 Households borrow the funds they need to
purchase new houses.
22
The Slope of the Demand Curve
A fall in the interest
Interest rate reduces the cost
Rate
of borrowing, which
7% increases the quantity
of loanable funds
demanded.
4%
Demand
($billions)
23
Equilibrium
The interest rate
Interest adjusts to equate
Rate Supply supply and demand.
The eq’m quantity

5% of L.F. equals
eq’m investment
and eq’m saving.
Demand
60 Loanable Funds
($billions)
24
Policy 1: Saving Incentives
Tax incentives for
Interest saving increase
Rate S1 S2 the supply of L.F.
…which reduces the

5% eq’m interest rate
4% and increases the
eq’m quantity of L.F.
D1
($billions)
25
Policy 2: Investment Incentives
An investment tax
Interest credit increases the
Rate S1 demand for L.F.
6%
…which raises the
and increases the
D2 eq’m quantity of L.F.
D1
($billions)
26
ACTIVE LEARNING 2
Budget deficits
 Use the loanable funds model to analyze
the effects of a government budget deficit:
 Draw the diagram showing the initial equilibrium.
 Determine which curve shifts when the
government runs a budget deficit.
 Draw the new curve on your diagram.
 What happens to the equilibrium values of the
interest rate and investment?
ACTIVE LEARNING 2
Answers
A budget deficit reduces
national saving and the
Interest S2 supply of L.F.
Rate S1
…which increases the

5% and decreases the
eq’m quantity of L.F.
and investment.
D1
($billions)
Budget Deficits, Crowding Out,
and Long-Run Growth
 Our analysis: Increase in budget deficit causes
fall in investment.
The govt borrows to finance its deficit,
leaving less funds available for investment.
 This is called crowding out.
 Recall from the preceding chapter: Investment
is important for long-run economic growth.
Hence, budget deficits reduce the economy’s
growth rate and future standard of living.
29
The U.S. Government Debt
 The government finances deficits by borrowing
(selling government bonds).
 Persistent deficits lead to a rising govt debt.
 The ratio of govt debt to GDP is a useful
measure of the government’s indebtedness
relative to its ability to raise tax revenue.
 Historically, the debt-GDP ratio usually rises
during wartime and falls during peacetime—until
the early 1980s.
30
U.S. Government Debt
as a Percentage of GNP, 1790–2012
120%
WW2
100%
Financial
80% Crisis
Revolutionary
60% War
Civil
War WW1
40%
20%
0%
1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010
CONCLUSION
 Like many other markets, financial markets are
governed by the forces of supply and demand.
 One of the Ten Principles from Chapter 1:
Markets are usually a good way
to organize economic activity.
Financial markets help allocate the economy’s
scarce resources to their most efficient uses.
 Financial markets also link the present to the future:
They enable savers to convert current income into
future purchasing power, and borrowers to acquire
capital to produce goods and services in the future.
32
Summary
• The U.S. financial system is made up of many
types of financial institutions, like the stock and
bond markets, banks, and mutual funds.
• National saving equals private saving plus
public saving.
• In a closed economy, national saving equals
investment. The financial system makes this
happen.
Summary
• The supply of loanable funds comes from
saving. The demand for funds comes from
investment. The interest rate adjusts to balance
supply and demand in the loanable funds
market.
• A government budget deficit is negative public
saving, so it reduces national saving, the supply
of funds available to finance investment.
• When a budget deficit crowds out investment,
it reduces the growth of productivity and GDP.

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Seventh Edition

Wojciech Gerson (1831-1901)

• What is Gross Domestic Product (GDP)?

For the economy as a whole,

Factors of Labor, land,

Goods are valued at their market prices, so:

Final goods: intended for the end user

GDP includes tangible goods

GDP includes currently produced goods,

GDP measures the value of production that occurs

Usually a year or a quarter (3 months)

Note: “Investment” does not

billions % of GDP per capita

Y $16,912 100.0 $53,350

C 11,537 68.2 36,394

I 2,738 16.2 8,637

G 3,137 18.5 9,895

NX –500 –2.9 –1,577

B. Sarah spends $1200 on a new laptop to use in her

D. General Motors builds $500 million worth of cars,

Compute nominal GDP in each year:

Compute real GDP in each year,

 The change in nominal GDP reflects both prices

$12 000 Real GDP

 One way to measure the economy’s inflation

Compute the GDP deflator in each year:

2011: 100 x (6000/6000) = 100.0

2013: 100 x (10,800/8400) = 128.6

Use the above data to solve these problems:

B. Compute real GDP in 2012.

Bangladesh China Japan

90% Bangladesh U.S.

Wojciech Gerson (1831-1901)

CHAPTER Measuring the

• What is the Consumer Price Index (CPI)?

5. Compute the inflation rate.

Compute CPI in each year usingInflation rate:year:

A. Compute the CPI in 2011.

B. What was the CPI inflation rate from 2011–2012?

A. Compute the CPI in 2011:

CPI in 2011 = 100 x ($150/$120) = 125

B. What was the inflation rate from 2011–2012?

In 2012, households bought {5 lbs beef, 25 lbs chicken}.

A. Compute cost of the 2012 household basket.

A. Compute cost of the 2012 household basket.

Amount Amount Price level today

Public 4-year $1,908 $8,893

Public 2-year $906 $3,264

Instructions: Express the 1990 tuition figures in 2013

Public 4-year (2010 $) $3,396 $8,893 161.9%

Public 2-year (current $) $906 $3,264

Public 2-year (2010 $) $1,612 $3,264 102.4%

A dollar amount is indexed for inflation

For example, the increase in the CPI automatically

Wojciech Gerson (1831-1901)

CHAPTER Saving, Investment,

• What are the main types of financial institutions

Saving = investment in a closed economy

Public saving = T – G = – 0.3

Taxes: T = G – 0.3 = 1.7

Private saving = Y – T – C = 10 – 1.7 – 6.5 = 1.8

National saving = Y – C – G = 10 – 6.5 = 2 = 1.5

Investment = national saving = 1.5

 Which of these two scenarios do you think is