ECONOMICS EXPLORE APPLY by Ayers and Collinge Chapter

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ECONOMICS: EXPLORE & APPLY by Ayers and Collinge Chapter 12 “Economic Growth” © 2004

ECONOMICS: EXPLORE & APPLY by Ayers and Collinge Chapter 12 “Economic Growth” © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 1

Learning Objectives 1. Identify the sources of economic growth. 2. Describe the role of

Learning Objectives 1. Identify the sources of economic growth. 2. Describe the role of savings and investment in the process of capital formation. 3. Analyze how taxation affects both savings and investment activity. 4. Provide justification for subsidized higher education. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 2

Learning Objectives 5. Summarize new growth theory and supply side economics 6. Discuss the

Learning Objectives 5. Summarize new growth theory and supply side economics 6. Discuss the key role of labor productivity in economic growth. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 3

12. 1 THE SEEDS OF ECONOMICS GROWTH • Economic growth is measured by the

12. 1 THE SEEDS OF ECONOMICS GROWTH • Economic growth is measured by the change in real GDP over time. – Sometimes a GNP measure is used instead. • Economies turn resources into outputs of greater value. – Over time the possibilities for doing so expand as the economy develops new technologies, and acquires new resources. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 4

Sources of Economic Growth o Most U. S. economic growth is attributable to increases

Sources of Economic Growth o Most U. S. economic growth is attributable to increases in labor and capital. o Both technological change and additional capital increase labor productivity. o Increases in labor productivity means that more GDP is produced for each hour worked by by the labor force. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 5

Annualized Growth Rates by Presidency PRESIDENCY YEARS GROWTH RATE Kennedy-Johnson 1961 -1968 4. 9

Annualized Growth Rates by Presidency PRESIDENCY YEARS GROWTH RATE Kennedy-Johnson 1961 -1968 4. 9 Nixon-Ford 1969 -1976 3. 0 Carter 1977 -1980 2. 7 Reagan 1981 -1988 3. 5 Bush 1 1989 -1992 1. 7 Clinton 1993 -1999 3. 7 Bush 2 2001 -2002(1) 2. 5 © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 6

Sources of Economic Growth 1. The growth rate increases in some years, decreases in

Sources of Economic Growth 1. The growth rate increases in some years, decreases in some years, and even falls in other years because of economic slowdowns. 2. When recession begins, labor productivity tends to fall as aggregate demand production decrease. 3. When recession nears it end, production at first increases, with no corresponding increase in employment, causing productivity to rise. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 7

Sources of Economic Growth q Labor productivity is associated with the amount of capital

Sources of Economic Growth q Labor productivity is associated with the amount of capital – both physical and human – labor has at its disposal. q The creation and accumulation of new capital is termed capital formation. q Capital formation requires initiative, and in market economies entrepreneurs make these choices based on profitability judgments. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 8

Nurturing Growth – Savings and Investment 1. Capital formation requires investment, which can be

Nurturing Growth – Savings and Investment 1. Capital formation requires investment, which can be coordinated centrally through government. 2. Investment can also be a decentralized process that responds to supply and demand in the marketplace. 3. Investors finance the capital formation that is necessary to take advantage of market opportunities. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 9

Nurturing Growth – Savings and Investment Firms invest when they wish to do any

Nurturing Growth – Savings and Investment Firms invest when they wish to do any of the following: © 2004 Prentice Hall Publishing Ø Expand their scale of operations. Ø Implement better production techniques. Ø Produce new goods that their old factories are illsuited to manufacture. Ayers/Collinge, 1/e 10

Nurturing Growth – Savings and Investment ü To acquire human capital, individuals invest in

Nurturing Growth – Savings and Investment ü To acquire human capital, individuals invest in themselves. ü Savings provides the capital for investment. ü Government reduces private savings and investment in two ways. ü It taxes away income that might be saved. ü It taxes the return on investments. ü In contrast, government also adds to investment. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 11

Nurturing Growth – Savings and Investment Without government, aggregate savings and investment would be

Nurturing Growth – Savings and Investment Without government, aggregate savings and investment would be the same. With government the situation is more complex because tax dollars can be directed towards government investment or government consumption. Investment + Government consumption = Savings + Taxation or, equivalently, Investment = Savings + Taxation - Government consumption © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 12

Nurturing Growth – Savings and Investment • Higher interest rates raise the cost of

Nurturing Growth – Savings and Investment • Higher interest rates raise the cost of investing. • A crowding out effect occurs when government borrowing is in competition with private-sector borrowing, and thus can cause higher interest rates. • Higher interest rates decrease investment. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 13

Nurturing Growth – Savings and Investment § Investment is also affected by the following

Nurturing Growth – Savings and Investment § Investment is also affected by the following factors. . § Business confidence § Current economic growth § Opportunities presented by technological change © 2004 Prentice Hall Publishing § Increases in any of these variables would shift the investment demand curve to the right. § Decreases would shift the investment demand curve to the left. Ayers/Collinge, 1/e 14

The Equilibrium Interest Rate Real Interest Rate As the interest rate gets lower, businesses

The Equilibrium Interest Rate Real Interest Rate As the interest rate gets lower, businesses borrow more… Supply of savings …and people save less. At equilibrium, the amount borrowed and saved is equal. Actual Interest Rate Actual savings and investment © 2004 Prentice Hall Publishing Demand for investment Savings and investments Ayers/Collinge, 1/e 15

12. 2 INFLUENCING GROWTH THROUGH PUBLIC POLICY q Private investors assess the expected return,

12. 2 INFLUENCING GROWTH THROUGH PUBLIC POLICY q Private investors assess the expected return, which is the value of the investment if successful, multiplied by the probability of success. q The actual return can be viewed as ex post, meaning after the fact. q Ex post, an investment might have turned out fabulously, or might have failed miserably. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 16

The Incentive Effects of Taxation v. In addition to regulation, taxes can also affect

The Incentive Effects of Taxation v. In addition to regulation, taxes can also affect growth. v. A tax on savings increases the market interest rate and discourages investment. v. Taxing the return to savings shifts the supply of savings to the left. v. There is concern over the low personal savings rate in the U. S. in recent years. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 17

The Incentive Effects of Taxation v. Investment is also discouraged by other taxes such

The Incentive Effects of Taxation v. Investment is also discouraged by other taxes such as the tax on capital gains. v. Capital gains represents the difference between the current market value of an investment and its purchase price. v. The capital gains tax takes a percentage of this difference when the investment is sold. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 18

Effects of the Income Tax Supply of savings Real Interest Rate Supply of savings

Effects of the Income Tax Supply of savings Real Interest Rate Supply of savings A tax on savings changes the market equilibrium for savings and investment. Higher interest rate Demand for investment Lower savings and investment © 2004 Prentice Hall Publishing Savings and investment Ayers/Collinge, 1/e 19

Subsidizing Research and Development Ø An external benefit occurs when some benefits are received

Subsidizing Research and Development Ø An external benefit occurs when some benefits are received by third parties who are not directly involved in a decision, such as the decision to research or invest. Ø Research is aimed at creating new products or otherwise expands the frontiers of knowledge and technology. Ø Development occurs when that technology is embodied into capital or output. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 20

Subsidizing Research and Development Ø External benefits are most prominent at the research stage.

Subsidizing Research and Development Ø External benefits are most prominent at the research stage. Ø Especially when the research involves the creation of knowledge that can be applied to the production of many different products. Ø It is difficult for any one investor or group of investors to assert property rights over the range of applications that can arise from basic advances in knowledge. Ø To correct this market failure the government subsidizes research. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 21

Subsidizing Research and Development Universities are often the source of valuable research, subsidized by

Subsidizing Research and Development Universities are often the source of valuable research, subsidized by government that companies fear to undertake on their own. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 22

12. 3 PROPERTY RIGHTS AND NEW GROWTH THEORY ü The prospect for business profits

12. 3 PROPERTY RIGHTS AND NEW GROWTH THEORY ü The prospect for business profits in the future can lead to research and development in the present. ü This idea is the cornerstone for what is called the new growth theory, which emphasizes the importance of new ideas in generating economic growth, and intellectual property rights in providing the profit incentive to generate those ideas. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 23

12. 4 SUPPLY-SIDE POLICY • Those economist who particularly emphasize policy aimed at growth

12. 4 SUPPLY-SIDE POLICY • Those economist who particularly emphasize policy aimed at growth are called supply-side economist, or supply-siders for short. • Supply-siders focus on increasing the value of what the economy can produce in the long-run (the supply side) rather than on any desire to change consumer’s spending behavior (the demand side). • Supply-siders feel that the short-run business cycle will sort itself out over time as long as the government does not intrude. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 24

Supply-Side Policy Ø The objective of supply-side policy is to ensure that output associated

Supply-Side Policy Ø The objective of supply-side policy is to ensure that output associated with full employment is as high as possible. Ø Supply-side policies are designed to increase productivity, such as through increasing capital formation. Ø Full-employment output will change in response to changes in structural features of the economy, including resources and technology. Ø Structural features also include government policies that change how workers and firms behave. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 25

Supply-Side Policy Critics refer to supply-side policies as trickle down economics. The term suggest

Supply-Side Policy Critics refer to supply-side policies as trickle down economics. The term suggest that the policies were intended to make the richer, so that they might spend a bit more and help the rest of us. This is not the process intended by supply-siders, instead they aim at increasing productivity, not spending. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 26

Supply-Side Policy Long-run Aggregate supply Price level Supply siders aim to get more output

Supply-Side Policy Long-run Aggregate supply Price level Supply siders aim to get more output from full employment Full-employment output © 2004 Prentice Hall Publishing Real GDP Ayers/Collinge, 1/e 27

The Laffer Curve Ø Increasing tax rates will increase tax revenues, but only up

The Laffer Curve Ø Increasing tax rates will increase tax revenues, but only up to a point. Ø After that point, higher tax rates are selfdefeating and actually reduce tax revenues. Ø At a rate of 100 percent, there would be no point to earning any income at all. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 28

The Laffer Curve Tax Revenue Maximum Tax Revenue 0% © 2004 Prentice Hall Publishing

The Laffer Curve Tax Revenue Maximum Tax Revenue 0% © 2004 Prentice Hall Publishing Tax rate 100% Ayers/Collinge, 1/e 29

How Technology Impacts Growth ü The ‘new’ U. S. economy is characterized by the

How Technology Impacts Growth ü The ‘new’ U. S. economy is characterized by the application of technology to increase business productivity. ü The growth of computers in the workplace increases the productivity of labor. ü Throughout history, the economy has been revitalized again and again by technologies like the railroad, the automobile, radio, television, and now the computer and the Internet. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 30

Sources of Changes in United States Labor Productivity 1979 -2000 Item 1970 to 1990

Sources of Changes in United States Labor Productivity 1979 -2000 Item 1970 to 1990 to 1995 to 2000 (1) Output per hour (labor productivity) 1. 6 1. 5 2. 7 (2) Contribution of capital 0. 8 0. 5 1. 1 (2 a)Contribution of information technology capital 0. 5 0. 4 0. 9 (2 b) Contribution of other capital 0. 3 0. 1 0. 2 (3) Contribution of labor 0. 3 0. 4 0. 3 (4) Contribution of technological change and other factors 0. 5 0. 6 1. 4 © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 31

12. 5 EXPLORE & APPLY The New Economy – Is It Real? v. In

12. 5 EXPLORE & APPLY The New Economy – Is It Real? v. In the 1990’s the “new economy” was characterized by the tremendous wealth creation in the Silicon Valley. v. The new economy is characterized by the application of technology to increase business productivity. v. The application of computer technology has been especially significant. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 32

Terms Along the Way § § § § economic growth labor productivity capital formation

Terms Along the Way § § § § economic growth labor productivity capital formation crowding-out effect expected return actual return capital gains © 2004 Prentice Hall Publishing § § § § capital gains tax external benefit research development property rights new-growth theory supply-side economists Ayers/Collinge, 1/e 33

Test Yourself 1. a. b. c. d. Technological change and additional capital increase labor

Test Yourself 1. a. b. c. d. Technological change and additional capital increase labor productivity. decrease labor productivity. have no effect on labor productivity. affect labor productivity in unpredictable ways. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 34

Test Yourself 2. a. b. c. d. U. S. economic growth has generally been

Test Yourself 2. a. b. c. d. U. S. economic growth has generally been characterized by a 5 percent or more growth rate since the 1960’s. varied with each president. was on a downward trend in the 1990’s, but has recently reversed its course. is no longer considered an important goal. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 35

Test Yourself 3. a. b. c. d. Capital formation is also referred to as

Test Yourself 3. a. b. c. d. Capital formation is also referred to as property rights. technology. the real interest rate. investment. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 36

Test Yourself 4. a. b. c. Investment equals savings + taxation + government consumption.

Test Yourself 4. a. b. c. Investment equals savings + taxation + government consumption. d. savings + taxation – government consumption. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 37

Test Yourself 5. a. b. c. Higher real interest rates increase the amount of

Test Yourself 5. a. b. c. Higher real interest rates increase the amount of investment. decrease the amount of investment. have no effect on the amount of investment. d. have varying and unpredictable effects on investment. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 38

Test Yourself 6. The Laffer curve shows that the effect of increasing taxes too

Test Yourself 6. The Laffer curve shows that the effect of increasing taxes too much is a. less economic growth. b. less tax revenue. c. more unemployment. d. that only the rich get richer. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 39

The End! Next Chapter 13 “Money, Banking, and the Federal Reserve" © 2004 Prentice

The End! Next Chapter 13 “Money, Banking, and the Federal Reserve" © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 40