What does strong economy mean?

• In the long-run strong means economic growth: rising productivity and increasing
standards of living.

• In the short-term, this refers to the business cycle: alternating periods of economic
expansion and economic recession.

• long-run economic growth, we mean the process by which rising productivity

increases the average standard of living.

• Measure of this average standard of living is real GDP per capita: the amount of
production in the economy, per person, adjusted for changes
in the price level.

• Wealthy countries have more resources to devote to health care, food, and sanitation.
All of which contribute to longer and healthier lives. Healthier citizens are more
productive.

Calculating Growth Rates and the Rule of 70

Over periods of a few years, we can average the growth rates to find the approximate annual
rate of growth:

A useful shortcut called the Rule of 70 can help us to determine how long it will take for an
economic variable to double:

So if the growth rate is 5%, 70/5= 14 it will take about 14 years for the variable to double.

What Determines the Rate of Long-Run Growth?

Increases in real GDP per capita rely on increases in labour productivity: the quantity of goods
and services that can be produced by one worker or by one hour of work.

So if increase in labor productivity are the key to long-run economic growth, what causes
labour productivity to grow?
Factors Affecting Labour Productivity Growth

Increases in capital per hour worked

Capital is a durable manufactured good that is used to produce other goods and services.

Technological change Improvements in methods to combine inputs into outputs (i.e. new
technologies) allow workers to produce more in a given period of time.

A very important point is that just accumulating more inputs—such as labour, capital, or
natural resources—will not ensure that an economy experiences economic growth unless
technological change also occurs.

Property Rights play an important role in determining economic growth.

Government plays a key role in enforcing property rights and contracts.
Government also plays an important role in regulating the financial system, providing
education, and infrastructure

Potential GDP refers to the level of real GDP attained when all firms are operating at
capacity. Capacity here refers to “normal” hours and a “normal” sized workforce. The
capacity of a firm is not the maximum output the firm is capable of producing.
Potential GDP rises when the labour force grows, new factories are built, new
equipment and machinery are installed and technological change takes place.

• “output gap,” the percentage difference between actual GDP and potential
GDP.
When the output gap is negative, actual real GDP is below potential real GDP and
the economy is not making full use of its resources.
When the output gap is positive, real GDP is above potential GDP and the economy
is using its resources in an unsustainable way or, more accurately, the economy is
using resources in a way that will lead to inflation.
negative output gap is associated with a recession.

Saving, Investment, and the Financial System

The process of economic growth depends on the ability of firms to expand their
operations, buy additional equipment, train workers, and adopt new
technologies. Firms can pay for some of these activities from retained earnings,
which are profits that are reinvested in the firm rather than paid to the firm’s
owners. For many firms, retained earnings are not sufficient to finance the rapid
expansion required in economies with high rates of economic growth.
Firms can also get funds from households, either directly through financial
markets—such as stock and bond markets—or indirectly through financial
intermediaries—such as banks. Financial markets and financial intermediaries
together make up the financial system.
Financial Markets: stock and bond markets
Financial Intermediaries: banks etc.

For the sake of simplicity, we will assume a closed economy, with no exports or
imports. Expression for investment:
I=Y−C−G
That is, investment in a closed economy is equal to income minus
consumption and government purchases.

SPrivate is all household income that is not spent.

SPrivate = Y + TR − C − T
Y= Payments received for factors of production
TR= Transfers from government
C= consumption
T= Taxes

SPublic = T − G − TR
the amount of tax revenue the government retains after paying for government
purchases and making transfer payments to households.

So total saving is:

S = SPrivate + SPublic
=Y−C–G
So we conclude that savings must equal investment:
S=I
When SPublic is zero, the government spends as much as it receives in taxes; this
is known as a balanced budget.
Negative and positive values for SPublic are known as budget deficits (-) and
budget surpluses (+) respectively.
Since the federal government funds its current deficits with borrowing (selling
bonds), this takes away from the money available for investment spending.
Put slightly differently, the government is using up some of the savings that
would have otherwise been used to finance investment. We can conclude that,
holding all other factors constant (ceteris paribus), there is a lower level of
investment spending in the economy when there is a budget deficit than when
the government has a balanced budget.
The Market for Loanable Funds (1 of 2)
market for loanable funds, where an (conceptual) interaction of borrowers and
lenders determine the market interest rate and the quantity of loanable funds
exchanged
An Increase in the Demand for Loanable Funds
demand for loanable funds is determined by the willingness of firms to borrow
money to engage in new investment projects. Suppose that technological
change occurs, so that investments become more profitable for firms.

the demand for loanable funds is downward sloping because the lower the
interest rate, the more investment projects firms can profitably undertake, and
the greater the quantity of loanable funds they will demand.
An Increase in the Supply of Loanable Funds
• The supply of loanable funds is determined by the willingness of
households to save and by the extent of government saving or dissaving.
Suppose household change their beliefs about saving and start saving
more at any interest rate.
At the new equilibrium, the real interest rate falls and quantity of funds loaned
increases

Because both borrowers and lenders are concerned with the real interest rate
they receive or pay, equilibrium in the market for loanable funds determines the
real interest rate rather than the nominal interest rate.
The Effect of a Budget Deficit on the Market for Loanable Funds
Suppose the government runs a budget deficit. To fund the deficit, it borrows
from households, decreasing the supply of funds available
to firms.
This raises the equilibrium real interest rate, and decreases the funds loaned to
firms.
crowding out: the decline in private expenditures as a result of an increase in
government purchases.
A government budget surplus has the opposite effect of a deficit. A budget surplus
increases the total amount of saving in the economy, shifting the supply of loanable
funds to the right. In the new equilibrium, the interest rate will be lower, and the quantity
of loanable funds will be higher. We can conclude that a budget surplus increases the
level of saving and investment.

Are Future Budget Deficits a Threat to

the Economy?
For the last several years, the federal government has spent more than it collected in
taxes. The 2018–2019 budget projected a deficit of $19.4 billion. The federal
government planned to spend $19.4 billion more than it planned to collect in taxes.
Budget deficits are often politically controversial, as higher deficits lead to higher
government borrowing.

Answer part (a) by explaining why higher federal budget deficits increase
federal borrowing and what impact higher federal borrowing has on national
savings. When federal tax receipts are less than federal spending, the
Canadian Treasury has to come up with the extra money by selling bonds.
These bonds represent federal borrowing. As we’ve seen, when the
government sells bonds, the government is subtracting from the total amount of
saving available by diverting funds into government bond purchases that would
have otherwise flowed into private saving.
Answer part (b) by explaining how an increase in federal borrowing reduces
Canada’s capital stock and by drawing a graph to illustrate your answer. An
increase in federal borrowing reduces total saving in the economy, thus shifting
the supply curve for loanable funds to the left. Your graph should look similar to
Figure 6.6. In the new equilibrium, the quantity of loanable funds is lower and,
therefore, so is the level of investment spending. When investment spending
falls, we add less to the capital stock every year, making it lower than it
otherwise would have been.
Answer part (c) by explaining why a smaller capital stock reduces productivity
and income. Investment spending is how the capital stock grows, so less
investment spending means a smaller capital stock. We’ve seen that increases
in the capital stock increase labour productivity by making more capital
available to workers and by providing the means for technological change to
occur. Smaller increases in labour productivity will result in slower increases in
real GDP per capita and, therefore, lower incomes than we would have
otherwise enjoyed.
The Effect of the Business Cycle on the Inflation Rate
The inflation rate is the percentage increase in the price level from one year to
the next.
• During expansions, demand for products is high relative to supply,
resulting in prices increasing—high inflation.
• During recessions, demand for products is low relative to supply,
resulting in prices increasing more slowly or even decreasing—low
inflation or deflation.

• Inflation tends to rise toward the end of an expansion and fall over the
course of each recession.
The Effect of the Business Cycle on the Unemployment Rate
As firms see their sales start to fall in a recession, they generally reduce
production and lay off workers.
unemployment often continues to rise after the end of each recession.

The consumer price index is a widely used measure of the inflation rate”? This
statement sounds like it might be correct, but it’s wrong.
the consumer price index is a measure of the price level, not of the inflation rate. We
can measure the inflation rate as the percentage change in the consumer price index
from one year to the next.

In macroeconomics, it is important not to confuse the level of a variable with the

change in the variable. To give another example, real GDP does not measure
economic growth. Economic growth is measured by the percentage change in real
GDP from one year to the next.

Do You Help the Economy More If You Spend or If You Save?

At the beginning of the chapter, we posed a question: Which of your two roommates is
right: The one who argues that you would help the economy more by saving your
income tax refund cheque, or the one who argues that you should spend it? In this
chapter, we have seen that consumption spending promotes the production of more
consumption goods and services—such as coffee and doughnuts—and fewer investment
goods and services—such as physical capital and education. Saving—not consuming—
is necessary to fund investment expenditure. So, saving your refund cheque will help
the economy grow over the long run. But if the economy is in a recession, spending
your refund cheque will spur more production of consumption goods. In a sense, then,
both of your roommates are correct: Spending your cheque will help stimulate the
economy during a recession, while saving it will help the economy grow over time.
You should also notice that the unemployment rate continues to rise even after
most economists believe that a particular recession has ended. This is typical,
and is caused by two factors.
First, even though employment begins to increase as a recession ends, it may
increase more slowly than the growth in the labour force that results from
population growth. If employment grows more slowly than the labour force, the
unemployment rate will rise. Further, some workers who became discouraged
during the recession and stopped looking for work (and therefore aren’t
classified as unemployed) re-enter the labour force once the economy begins to
recover. These returning workers increase the number of people in the labour
force.
Second, not all firms expand at the same rate after a recession. Some firms that
laid off workers during a recession may be particularly slow to call workers back
even after a recession is over.

Summary
Financial markets and financial intermediaries together comprise the financial system. A
well-functioning financial system is an important determinant of economic growth.
Firms acquire funds from households, either directly through financial markets—such
as the stock and bond markets—or indirectly through financial intermediaries— such as
banks. The funds available to firms come from saving. There are two categories of
saving in the economy: private saving by households and public saving by the
government. The value of total saving in the economy is always equal to the value of
total investment spending. In the model of the market for loanable funds, the interaction
of borrowers and lenders determines the market interest rate and the quantity of
loanable funds exchanged.

2.6 Consider the following data for a closed economy:

Use these data to calculate the following:

1. Private saving
2. Investment spending
3. Transfer payments
4. The government budget deficit or budget surplus

Ps= Y + Tr – T – C (missing Tr)

Total saving= Y – C – G
12 – 8 – 2 = 2

Total savings= S= 2

Private Savings= total savings – public savings

Ps= 2 – (-0.5) = 2.5

I= total saving

Public + private savings

I= 2

Transfer payment

Ps 2.5= 12 + X – 2 – 8

X= 0.5

2.5= 12+0.5-2-8

Tr = 0.5

Budged deficit = public savings = -0.5

The increase in real GDP per capita is likely to be less than the true increase in living standards
because this measure does not account for the existence of new products, increases in
life expectancy, and other advances.

No agency in Canada is responsible for declaring when recessions begin and end. Can you think
of reasons why Statistics Canada, which is a federal government agency, might not want to
take on this responsibility?

For a given demand for loanable funds, an increase in the interest rate does decrease the
quantity of loanable funds demanded, but it also increases the quantity of loanable funds
supplied.

The Canadian federal government’s budget deficit was $35.3 billion in 1991 and $34.4
billion in 1992. A student comments, “The government must have acted between 1991
and 1992 to raise taxes or cut spending, or possibly both.” Do you agree? Briefly
explain

: Explain how changes in the budget deficit can occur without government action.
If government takes action to raise taxes or cut spending, the federal budget deficit will
decline. But the deficit will also decline automatically when GDP increases, even if the
government takes no action. When GDP increases, rising household incomes and firm
profits result in higher tax revenues. Increasing GDP also usually means falling
unemployment, which reduces government spending on programs for the unemployed
(Employment Insurance in Canada). So, you should disagree with the comment. A
falling deficit does not mean that the government must have acted to raise taxes or cut
spending.

Should the Federal Budget Always Be Balanced?

Although many economists believe that it is a good idea for the federal government to
have a balanced budget when the economy is at potential GDP, few economists believe
that the federal government should attempt to balance its budget every year. To see why
economists take this view, consider what the government would have to do to keep the
budget balanced during a recession, when the federal budget automatically moves into
deficit. To bring the budget back into balance, the government would have to raise taxes
or cut spending, but these actions would reduce aggregate demand, thereby making the
recession worse. Similarly, when GDP increases above its potential level, the budget
automatically moves into surplus. To eliminate this surplus, the government would have
to cut taxes or increase government spending. But these actions would increase
aggregate demand, thereby pushing GDP even further beyond potential GDP and
increasing the risk of higher inflation. To balance the budget every year, the government
might have to take actions that would destabilize the economy.

Some economists argue that the federal government should normally run a budget
deficit, even when the economy is at potential GDP. When the federal budget is in
deficit, the government sells bonds to investors to raise the funds necessary to pay the
government’s bills. Borrowing to pay the bills is a bad idea for a household, a firm, or a
government when the bills are for current expenses, but it isn’t necessarily a bad policy
if the bills are for long-lived capital goods. For instance, most households pay for a
home by taking a 15- to 25-year mortgage. Because houses last many years, it makes
sense to pay for a house out of the income the household earns over a long period of
time rather than out of the income received in the year the house is bought. Businesses
often borrow the funds to buy machinery, equipment, and factories by selling long-term
corporate bonds. Because these capital goods generate profits for the businesses over
many years, it makes sense to pay for them over a period of years as well. By similar
reasoning, when the federal government contributes to the building of a new highway,
bridge, or subway, it may want to borrow funds by selling bonds. The alternative is to
pay for these long-lived capital goods out of the tax revenues received in the year the
goods were purchased. But that means that the taxpayers in that year have to bear the
whole burden of paying for the projects, even though taxpayers for many years in the
future will get to enjoy the Benefit
The Federal Government Debt
Every time the federal government runs a budget deficit, the government must borrow
funds from investors by selling bonds. When the federal government runs a budget
surplus, it pays off some existing bonds. Figure 12.14 shows that there are many more
years of federal budget deficits than years of federal budget surpluses. As a result, the
total number of bonds outstanding has grown over the years. The total value of bonds
outstanding, which is equal to the sum of past budget deficits, is referred to as the
federal government debt. Each year the federal budget is in deficit, the federal
government debt grows. Each year the federal budget is in surplus, the debt shrinks.

Figure 12.15 shows federal government debt since 1967. The debt has been increasing
over virtually the entire period. The exception is the period from 2000 to 2008, during
which the debt either fell or increased very little. You can see a major increase in the
debt from 1980 to 1998. While federal government debt would have naturally increased
during the recessions that took place in this period, it also increased when the economy
was growing. In 2000, the debt actually began to fall. This trend continued until 2009,
when the debt increased dramatically. This spike in the debt was a result of Canada’s
Economic Action Plan. When we consider the gross federal government debt, it’s
important to keep a couple of points in mind. First, we haven’t controlled for changes in
the value of the

Is Government Debt a Problem?

Debt can be a problem for a government for the same reasons that debt can be a
problem for a household or a business. If a household has difficulty making the monthly
mortgage payment, it will have to cut back on spending for other things. If the
household is unable to make payments, it will have to default on the loan and will
probably lose its house. The federal government is in no danger of defaulting on its
debt. Ultimately, the government can raise the funds it needs through taxes to make the
interest payment on the debt. If the debt becomes very large relative to the economy,
however, the government may have to raise taxes to higher levels or cut back on many
other types of spending to make the interest payments on the debt. Interest payments are
currently about 11 percent of total federal expenditures. At this level, tax increases or
significant cutbacks in other areas aren’t required.

In the long run, a debt that increases in size relative to GDP, as was happening after
2009, can pose a problem. As we discussed previously, crowding out of investment
spending may occur if an increasing debt drives up interest rates. Lower investment
spending means a lower capital stock in the future and a lower capacity of the economy
to produce goods and services. This effect is somewhat offset if some of the government
debt was incurred to finance improvements in infrastructure, such as bridges, roads, and
ports; to finance education; or to finance resea