Wednesday, February 17, 2010

Economic Growth: Savings and Investments

The Very Long Run: Economic Growth Models

We can measure long run economic as the annual percentage change in per-capita real potential GDP.
Ecoonomic growth causes Y* to move to the right.

The standard of living is measured by the per capita real actual GDP: The average income generated by each individual within an economy

Although a small difference in growth rates may not seem to make a huge difference, compounded over time, smaller changes in growth rates can have a huge impact on economic growth!
-1% growth rate increases GDP by 10% in 10 years
-7% growth rate increases GDP by 100% in 10 years

Even a small change in the growth rate can cause major long term changes in terms of living standards- much more than gap-busting can, anyways...

Malthus thought that output would not be able to grow at a fast enough rate to keep up with population growth

In this unit, we're going to be studying the depressing, Neoclassical growth model, and then we'll be looking at some more optimistic modern growth models.

(As a general note, most asian countries have a much larger growth rate than the rest of the world, currently. This is because they are developing rather rapidly!)


What are some benefits of economic growth?
-Growth may increase the standard of living, as long as the economy is growing more quickly than the population. This means that people are able to buy more crap!
-Economic growth may help governments to alleviate poverty- the more national wealth a country has access to, the greater their ability to redistribute that wealth to those who are worse off.

What are the costs of economic growth?

1: Opportunity Cost: In order to allow for economic growth, individuals need to divert resources away from present consumption and into investment (ie: savings). For an example, a government has the option of spending 100 million dollars on new parks and public spaces now, OR it can spend that money on educating it's citizens, which won't generate any immediate benefit, but will create better workers and a stronger tax base 20 years into the future

2: Personal hardships to those who can't adapt to change (ie: the poor old blacksmith who goes out of business and doesn't want to retrain for a new job more befitting of the information age)

-Resource Depletion
-Global Warming
-Financial Meltdown
-Reduced Happiness (if you want to see this sort of thing in action, check out Carl Honore's "In Praise of Slowness"

Well, as we learned in the last chapter, in the long run, output is a function of the supply of factors (usually capital and labour, and this includes embodied increases in quality, not just quantity), and productivity (which can also by thought of as technological change)

In this chapter, we flip this idea around and reconfigure it, to state that we have four determinants of growth

1: Supply of labour: the quantity of labour
2: Human capital: the quality of labour (this is acquired through on-the-job training and education)
3: Physical capital: both the quantity and quality of plant, equipment, inventories, and residential construction
4: Technological change: This is sort of a catch-all category for all sorts of different changes, including changes in the productive process, innovation and invention (creative new ideas), new products, new organizations and many other things!

-Economic growth occurs in the long run, and related to increasing Y*, not output gaps

Long run growth is determined, largely, by investment and savings. In a nutshell, savings allows for more investment, and greater investment in productive capital increases potential output in the long run

In the short run, we assume that the interest rate is constant, so we use the equilibrium condition savings must = investments and use this to determine output
In the long run, we assume that potential GDP is constant, We also see that both savings and investment are a function of the interest rate, so we use the equilibrium condition S = I to determine what the equilibrium interest rate will be.

In this model of savings, we focus on public savings, which is a combination of private savings (Y* - C - T) and public savings (G - T)

NS = (Y* - C - T) + (T - G)
NS = Y* - C - G

When the interest rate increases, we know that consumption will decrease (because the opportunity cost of borrowing money has risen). When consumption decreases while income remains the same, national savings increases. As a result, high interest rates encourage more people to save money, and as a result, this creates a larger "pot" of loanable funds which accumulates in banks. Basically national savings as a function of interest rates is positively sloped.

What about investment????? Well, we use the marginal efficiency of investment curve to measure the degree of investment as a function of interest rates: this curve basically shows the demand for investment at each interest rate
This curve is negatively sloped. As interest rates rise, the opportunity cost of borrowing money to fund new investments also increases, which leads to decreased desired investment.

SO... what happens when we graph both desired national savings and desired investment together? We get two criss-crossing curves! The point where the two curves intersect is where NS = I: this is the equilibrium point- it does not change over time. If there is an excess supply of funds, this will mean that banks do not need to charge as much interest to prospective borrowers, so the interest rates will naturally fall, which drives up investment until it is equal to savings. Likewise, if there is excess demand for loanable funds, banks will know that that loaning out money when there are not many hard assets to cover their asses should the loan go unpaid is RISKY BUSINESS, so they will charge higher interest rates to compensate for this risk. Higher interest rates, likewise, discourages excess investment and encourages national savings until the economy is in equilibrium once again!

An increase in either public savings OR in the marginal efficiency of investment causes the level of equilibrium savings and investment to increase. This increased investment leads to long term increases in potential national income (because investment allows for the accumulation of new capital production factors). As such, although savings can be bad for an economy in the short run (because increased savings puts recessionary pressure on an economy), they are good in the long run, because they create opportunities for new growth! Woooooooooooo!

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