Chapter 5: Economic Growth, the Financial System and Business Cycles

Question 1

What is a successful economy?

Answer 1

One that is capable of increasing the production of goods and services faster than the average person in a country can increase.

Question 2

What is the business cycle?

Answer 2

Alternating periods of economic expansion and economic contraction relative to the long-term trend rate of economic growth.

Question 3

What is long-run economic growth?

Answer 3

The process by which rising productivity increases the average standard of living. The process of long-run economic growth brought the typical Australian from the standard of 1901 to the standard of living of today.

Question 4

What is the best measure of the standard of living?

Answer 4

Real GDP per person (aka real GDP per capita). Real GDP is used instead of nominal GDP in order to adjust for changes in price level over time.

Question 5

How to calculate the average economic growth rate for shorter periods?

Answer 5

This is done by averaging the growth rate for each year. For example, real GDP in Australia grew by approximately 2.8% in 2014, 2.2% in 2015 and 3.0% in 2016:
(2.8% + 2.2% + 3.0%) / 3 = 2.7%

Question 6

How to calculate long-run economic growth?

Answer 6

We usually shorten ‘average annual growth rate’ to ‘growth rate’. We can judge how rapidly an economic variable is growing by calculating the number of years it would take to double. One easy way to calculate approximately how many years it will take real GDP per capita to double is to use the rule of 70.

Question 7

What is the formula for the rule of 70?

Answer 7

Number of years to double = 70/growth rate
e.g.
If real GDP per capita is growing at a rate of 5% per year, it will double in 70/5 = 14 years.
If real GDP per capita is growing at a rate of 2% per year, it will double in 70/2 = 35 years.

Question 8

What determines the rate of long-run economic growth?

Answer 8

This is focused on in chapter 6. However, chapter 5 does discuss the basic point that increases in real GDP per capita depend on increases in labour productivity.

Question 9

What is labour productivity?

Answer 9

The quantity of goods and services that can be produced by one worker or by one hour of work.

Question 10

What 2 factors do economist believe determine labour productivity?

Answer 10

1. The quantity of capital per hour worked.
2. The level of technology
   Therefore, economic growth occurs if the quantity of capital per hour worked increases and there is technological change.

Question 11

Explain the following factor which determines labour productivity: increases in capital per hour worked

Answer 11

As the capital stock per hour increases, worker productivity increases. A baker can produce more bread per hour with a larger oven. A university lecturer can lecture to more students with a larger lecture theatre. In explaining economic growth, economists take int account not just physical capital, like computers and factories, but also human capital.

Question 12

What is capital?

Answer 12

Manufactured goods that are used to produce other goods and services?

Question 13

What is human capital?

Answer 13

The accumulated knowledge and skills works acquire from education and training or from their life experiences.

Question 14

Explain the following factor which determines labour productivity: technological change

Answer 14

Technology refers to the processes a firm uses to turn inputs into outputs of goods and services. Technological change is an increase in the quantity of output firms can produce using a given quantity of inputs.

Question 15

Explain the following factor which determines labour productivity: property rights

Answer 15

An additional requirement for economic growth is that the government must provide secure rights to private property. A market system cannot function unless rights to private property are secure. In addition, the government can help the market work and aid economic growth by establishing an independent court system that enforces contracts between private individuals.

Question 16

What is potential GDP?

Answer 16

The level of GDP attained when all firms are producing at normal capacity. The capacity of a firm is not the maximum output the firm is capable of producing.
e.g. a car assembly place could operate 24 hours per day for 52 weeks per year and would be at its maximum production level. The plants capacity, however, is measured by its production when operating on normal hours, using a normal workforce.

Question 17

What does the process of economic growth depend on?

Answer 17

The ability of firms to expand their operations, buy additional equipment, train workers and adopt new technologies. Firms can finance some of these activities from retained earnings, but mostly firms acquire funds from households, either directly through financial markets (such as the share and bond markets) or indirectly through financial intermediaries (such as banks).

Question 18

What are retained earnings?

Answer 18

These are profits that are reinvested in the firm rather than taken out of the firm and paid to the firm’s owners.

Question 19

What is the financial system?

Answer 19

The system of financial markets and financial intermediaries through which firms acquire funds from households. Without a well-functioning financial system, economic growth is impossible because firms will be unable to expand and adopt new technologies with it.

Question 20

What are the key components of the financial system?

Answer 20

• Financial markets

- Financial intermediaries

Question 21

What are financial markets?

Answer 21

Markets where financial securities, such as shares and bonds, are bought and sold.
Financial security = a document (often in electronic form) that states the terms under which funds pass from the buyer of the security (who is lending funds) to the seller.
Shares = financial securities that represent partial ownership of a firm.
Bonds = financial securities that represent promises to repay a fixed amount of cash.

Question 22

What are financial intermediaries?

Answer 22

Firms such as banks and non-bank financial intermediaries (NBFIs) (which include credit unions, building societies, managed funds, superannuation funds and insurance companies) that borrow funds from savers and lend them to borrowers.

Question 23

What services does the financial system provide?

Answer 23

It provides three key services for savers and borrowers: risk sharing, liquidity and information.

Question 24

What is risk?

Answer 24

This is the chance that the value of a financial security will change relative to what you expect.

Question 25

What is risk sharing?

Answer 25

The financial system provides risk sharing by allowing savers to spread their money over many financial investments. For example, you can divide your money between a bank certificate of deposit, individual bonds, shares and a managed fund.

Question 26

What is liquidity?

Answer 26

It is the ease with which a financial security can be exchanged for cash. The financial system provides the service of liquidity by providing savers with markets in which they can sell their holdings of financial securities.

Question 27

What is a key point in the macroeconomics of saving and investment?

Answer 27

That the total value of saving in the economy must equal the total value of investment.

Question 28

What is the GDP equation?

Answer 28

Y = C + I + G + NX

Remember that GDP is a measure of both total production in the economy and total income (Y).

Question 29

What are the components of GDP?

Answer 29

C = consumption
I = investment
G = government purchase
NX = net exports

Question 30

What are the components of GDP in an open economy?

Answer 30

Y = C + I + G

Question 31

What is the savings equals investment condition?

Answer 31

If we rearrange the open economy GDP, we obtain an expression for investment in terms of the other variables:
I = Y – C – G
This expression tells us that in a closed economy, investment spending is equal to total income minus consumption spending and minus government purchases.

Question 32

What is the total savings of the economy?

Answer 32

S = S (private) + S (public) OR 
S = (Y – C – T) + (T – G) OR
S = Y – C – G OR
S = I
Explanation: 
S (private) = Y – C – T
Households receive income for supplying the factors of production to firms. This portion of household income is equal to Y.
S (public) = T – G
The government also engages in saving. Public saving equals the amount of net tax revenue the government retains after paying for government savings.

Question 33

What is a balanced budget?

Answer 33

When the government spends the same amount that it collects in taxes.

Question 34

What is a budget deficit?

Answer 34

When the government spends more than it collects in taxes. In this case, T is less than G, which means that public saving is negative. Negative saving is also known as dissaving.

Question 35

How can public saving be negative?

Answer 35

When the federal government runs a budget deficit, the RBA sells government financial securities such as bonds to borrow the money necessary to fund the gap between taxes and spending.

Question 36

What is a budget surplus?

Answer 36

When government spending is less than its net taxes. A budget surplus increases public saving and the total level of saving in the economy. A higher level of saving results in a higher level of investment spending.

Question 37

What is the market for loanable funds?

Answer 37

The interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged.

Question 38

What is the demand for loanable funds determined by?

Answer 38

The willingness of firms to borrow funds to engage in new investment projects, such as building new factories or engaging in R&D of new products.

Question 39

What is the supply of loanable funds determined by?

Answer 39

In a closed economy it is determined by the willingness of households to save and by the extent of government saving or dissaving.

Question 40

What does equilibrium in the market for loanable funds determine?

Answer 40

It determines the REAL interest rate and the quantity of loanable funds exchange.

Question 41

Describe the market for loanable funds: figure 5.3

Answer 41

Y-axis: real interest rate (%)
X-axis: Loanable funds (dollars per year)
D = demand for loanable funds curve (downward sloping)
S = supply of loanable funds curve (upward sloping)
E = equilibrium interest rate and equilibrium quantity of loanable funds

Question 42

What happens when households save?

Answer 42

They reduce the amount of goods and services they can consume and enjoy today.

Question 43

What determines the willingness of households to save rather than consumer their incomes today?

Answer 43

This is determined by the interest rate they receive when they lend their savings.
- The higher the interest rate, the greater the reward for saving and the larger the amount of funds households will save.

Question 44

What is the nominal interest rate?

Answer 44

This is the stated interest rate on a loan.

Question 45

What is the real interest rate?

Answer 45

This corrects the nominal interest rate for the impact of inflation and is equal to the nominal interest rate minus the inflation rate.

Question 46

What happens when there is an increase in the demand for loanable funds?

Answer 46

An increase in demand for loanable funds increases the equilibrium interest rate from i1 to i2 and increases the equilibrium quantity of loanable funds from L1 to L2. As a result, saving and investment both increase (due to the demand curve shifting to the right).

Question 47

What is crowding out?

Answer 47

A decline in private expenditure as a result of an increase in government purchases.

Question 48

What is the effect of a budget deficit on the market for loanable funds?

Answer 48

Running a budget deficit reduces the level of total saving in the economy and, by increasing the interest rate, also reduces the level of investment spending by firms. By borrowing to finance its budget deficit, the government will have crowded out some firms that would otherwise have been able to borrow to finance investment.
When the government begins running a budget deficit, the supply for loanable fuds shifts to the left. The equilibrium increases from i1 to i2 and the equilibrium quantity of loanable funds falls from L1 to L2. As a result, saving and investment both decline.

Question 49

What is the effect of a budget surplus on the market for loanable funds?

Answer 49

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.

Question 50

In practice what is the impact of government budget deficits and surpluses?

Answer 50

In practice the impact of the state of the budget on the equilibrium interest rate is relatively small. However, this small effect on interest rates, does not imply that we can ignore the effect of deficits on economic growth.

Question 51

What is the expansion phase of the business cycle?

Answer 51

This is where production, employment and income are increasing at a rate that is above the trend rate in growth that the economy experiences over time.

Question 52

What is a business cycle peak?

Answer 52

The end of the period of expansion.

Question 53

What is the contraction phase of the business cycle?

Answer 53

This is where production, employment and income are growing at a rate that is below trend. This may be followed by a recession.

Question 54

What is a recession?

Answer 54

This occurs when total production and employment are decreasing and the rate of economic growth is negative.

Question 55

What is a business cycle trough?

Answer 55

This is the end of the contraction or recession phase as a period of expansion begins.

Question 56

What happens during the business cycle?

Answer 56

Each business cycle is different. The lengths of the expansion and contraction phases and which sectors of the economy are most affected will rarely be the same in any two cycles. But most business cycles share certain characteristics, which we will discuss in this section.

Question 57

What happens to the economy as it nears the end of expansion?

Answer 57

Interest rates are usually rising and the wages of workers are usually rising faster than prices. As a result of rising interest rates and rising wages, the profits of firms will be failing. Typically, towards the end of expansion, both households and firms will have substantially increased their debts.

Question 58

What happens to the economy at the beginning of a contraction?

Answer 58

This will often begin with a decline in spending by firms on capital goods such as machinery equipment, new factories and new office buildings, or by households on new houses and consumer durables, such as furniture and cars. As spending declines, firms selling capital goods and consumer durables will find their sales declining. As sales decline, firms cut back on production and begin to lay off workers or reduce hours of work. Rising unemployment, underemployment and falling profits reduce income, which leads to further declines in spending, and a recession may occur.

Question 59

What is the effect of the business cycle on car sales?

Answer 59

Durable goods are affected more by the business cycle than non-durables. During an economic contraction or recession, workers reduce spending if they lose their jobs, fear losing their jobs or suffer wage reductions. Because people can often continue using their existing furniture, appliances or cars, they are more likely to postpone spending on durables than spending on other goods. In turn, since cars are among the most expensive products consumers buy, consumers are very likely to postpone buying a new one during a contraction or a recession.

Question 60

What are durables?

Answer 60

These are goods that are expected to las for three or more years.
Consumer durables = furniture, appliances and cars.
Producer durables = machines, tools, vehicles and some computer equipment.

Question 61

What are non-durables?

Answer 61

Goods that are expected to last for fewer than 3 years.

Consumer non-durables = food and clothing or services such as haircuts and medical care.

Question 62

What is the effect of the business cycle on the inflation rate?

Answer 62

The price level measures the average prices of goods and services in the economy, and the inflation rate is the percentage increase in the price level from one year to the next.
An important fact about the business cycle is that during economic expansions the inflation rate usually increases, particularly near the end of the expansion, and during contractions the inflation rate usually decreases. The exception to this is if the expansion is due to rising productivity levels and an expansion of potential GDP, or if the contraction is caused by high prices for production inputs, such as very high oil prices, or if real wages rise at a rate that is faster than the rate at which labour productivity increases.

Question 63

What is the effect of the business cycle on the unemployment rate?

Answer 63

Contractions and recessions cause the unemployment rate to increase while expansions and booms cause the unemployment rate to decrease. During a contraction, firms see their sales decline and they begin to reduce production, lay off workers or reduce hours of work.

Question 64

Why does the unemployment rate tend to rise even though a recession has ended?

Answer 64

This is typical due to 2 factors:

1. During the business cycle, discouraged workers (unemployed people who have given up hope finding a job and stop looking for one) drop out and then return to the labour force as the recession ends (as job prospects are more optimistic).
2. Firms continue to operate well below their capacity even after the recession has ended and production has begun to increase. As a result, at first, firms may not re-hired all of the workers they have laid off and may even continue for a while to lay off workers

Question 65

Why are recessions partly due to business cycles and partly due to shocks?

Answer 65

Although today the Australian economy still experiences business cycles, the cycles have become milder. The biggest downturns in economic growth rates and high unemployment in Australia have largely been due to ‘shocks’ to the economy because of, sometimes, international factors, and sometimes, events specific to Australia such as poor economic management.

Question 66

Why did the GFC occur?

Answer 66

The GFC originated in the US as a result of very poor credit standards, high levels of borrowing (arguably assisted by the low interest rate policy of the US Federal Reserve Bank and enabled by China’s surplus of funds) and asset price bubbles (shares and real estate priced higher than their underlying value).
The lack of financial regulation by both the US government and its financial industry allowed home loans to be made to an enormous number of households that were not in a position to repay them. People were able to buy homes with no deposit, very low incomes, poor credit histories, sometimes even when they were unemployed, and could, in some instances, borrow up to 110% of the value of their properties.
The risk of these ‘sub-prime mortgages’ was spread as they were repackaged and sold as financial assets to other financial institutions in many parts of the world. Therefore, when the inevitable loan defaults began to emerge towards the end of 2007, the impact spread throughout much of the world.

Question 67

Why did Australia’s financial system have a minimal exposure to ‘toxic’ debts?

Answer 67

Due to existing prudential regulations which were tightened by the then Federal Treasurer, Peter Costello, and due to more responsible lending behaviour and low exposure to risky assets by the majority of Australian banks and financial institutions.

Question 68

Why are business cycles less severe today?

Answer 68

1. The increasing important of services and the declining importance of goods.
2. The establishment of unemployment benefits and other government transfer programs that provide funds to the unemployed.
3. Active federal government and central bank policies to stabilise the economy.
4. The stability of the financial system.