The Real Economy in the Long Run

1. Production and Growth

1.1 Productivity: Its Role and Determinants

Productivity:

• the quantity of goods and services produced from each unit of labor input

• Productivity = Y / L

  • Y is the amount of total produced goods and services
  • L is the quantity of labor force

How can workers be more productive?

Physical Capital (K) per Worker

• Physical Capital: the stock of equipment and structures that are used to produce goods and services

Human Capital (H) per Worker

• Human Capital: the knowledge and skills that workers acquire through education, training, and experience

Natural Resources (N) per Worker

• Natural Resources: the inputs into the production of goods and services that are provided by nature, such as land, rivers, and mineral deposits

Technological Knowledge (A)

• society’s understanding of the best ways to produce goods and services
• Metaphor: technological knowledge is the quality of society's textbooks, whereas human capital is the amount of time that the population has devoted to reading them.

Formulate the production function: $$ \begin{aligned} Y &= A \cdot F(L, K, H, N) \ \Rightarrow {Y \over L} &= A \cdot F(1, {K \over L}, {H \over L}, {N \over L}) \end{aligned} $$

An example:

1.2 Economic Growth and Public Policy

1.2.1 Saving and Investment

capital is a produced factor of production \(\Rightarrow\) increase the amount of capital

If today the economy produces a large quantity of new capital goods \(\Rightarrow\) tomorrow it will have a larger stock of capital and be able to produce more goods and services.

\(\Rightarrow\) invest more current resources in the production of capital

\(\Rightarrow\) sacrifice consumption of goods and services in the present to enjoy higher consumption in the future

Encouraging saving and investment is one way that a government can encourage growth and, in the long run, raise an economy’s standard of living.

1.2.2 Diminishing Returns and the Catch-Up Effect

Diminishing returns: the property whereby the benefit from an extra unit of an input declines as the quantity of the input increases

Catch-up effect: the property whereby countries that start off poor tend to grow more rapidly than countries that start off rich

Higher saving rate \(\Rightarrow\) lower amount of consumption \(\Rightarrow\) lower level of happiness

Solow Model: there exists an optimal saving rate

1.2.3 Investment from Abroad

foreign direct investment: A capital investment that is owned and operated by a foreign entity

foreign portfolio investment: An investment that is financed with foreign money but operated by domestic residents

Investment from abroad is one way for a country to grow.

• Even though some of the benefits from this investment flow back to the foreign owners, this investment does increase the economy’s stock of capital, leading to higher productivity and higher wages.
• Moreover, investment from abroad is one way for poor countries to learn the state-of-the-art technologies developed and used in richer countries.

1.2.4 Others

education: investment in human capital

health and nutrition

property rights and political stability

free trade

research and development

2. Saving, Investment, and the Financial System

2.1 Financial Institutions

Financial system: the group of institutions in the economy that help to match one person’s saving with another person’s investment

2.1.1 Financial Markets

Financial markets: financial institutions through which savers can directly provide funds to borrowers

Bond: a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond

• date of maturity: the time at which the loan will be repaid
• rate of interest that will be paid periodically until the loan matures

Stock: a claim to partial ownership in a firm

equity finance:

• equity (股权): the value of the shares issued by a company
• a method of raising fresh capital by selling shares of the company to public, institutional investors, or financial institutions (股权融资)

stock exchanges:

• the New York Stock Exchange
• NASDAQ (National Association of Securities Dealers Automated Quotation)
  • security: tradable financial asset (证券)
  • quotation: a formal statement setting out the estimated cost for a particular job or service (行情)

If a company runs into financial difficulty, the bondholders are paid what they are due before stockholders receive anything at all.

2.1.2 Financial Intermediaries

Financial intermediaries: financial institutions through which savers can indirectly provide funds to borrowers

Banks

Mutual fund: an institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds

2.2 Saving and Investment in the National Income Accounts

For a closed economy,

\[ \begin{aligned} Y &= C + I + G ~~~~ \text{// what make up GDP Y} \\ S &:= Y - C - G = I ~~~~ \text{// national saving S equals investment I} \\ S &= (Y - T - C) + (T - G) \end{aligned} \]

\(T\) : the amount that the gov. collects from households in taxes minus the amount it pays back to households in the form of transfer payments

\(Y - T - C\) : private saving

\(T - G\) : public saving

• \(T > G\) : budget surplus
• \(T < G\) : budget deficit

Difference between saving and investiment

Someone earns more than he spends. He deposits his unspent income in a bank or uses it to buy some stock or a bond from a corporation. Both of the actions are classified as saving rather than investment.

In macroeconomics, investment refers to the purchase of new capital, such as equipment or buildings.

2.3 The Market for Loanable Funds

loanable funds: the flow of resources available to fund private investment

2.3.1 Saving Incentives

↓ saving rate: e.g. tax on interest income

↑ saving rate: reduce tax on interest income ⇒ higher saving rate ⇒ more loanable funds ⇒ lower interest rate ⇒ more investment

2.3.2 Investment Incentives

Investment tax credit ⇒ demand curve shifts right ⇒ interest rate ↑ ⇒ greater saving

Crowding out: a decrease in investment that results from government borrowing

• 
• public saving ↓ ⇒ interest rate ↑ ⇒ investment ↓ ⇒ growth rate ↓

3. Unemployment

3.1 Identifying

Adults (age 16 and older) are divided into 3 categories:

• Employed: full-time and part-time

  worked as paid employees

  worked in their own business

  worked as unpaid workers in a family member’s business

  not working but who had jobs from which they were temporarily absent because of, for example, vacation, illness, or bad weather.

• Unemployed:

not employed, were available for work, and had tried to find employment during the previous four weeks

waiting to be recalled to a job from which they had been laid off

• Not in the labor force: neither of the first two categories

such as full-time students, homemakers, and retirees

\[ \begin{aligned} \text{Labor force} &= \text{Number of employed} + \text{Number of unemployed} \\ \text{Unemployment rate} &= {\text{Number of unemployed} \over \text{Labor force}} \\ \text{Labor-force participation rate} &= {\text{Labor force} \over \text{Adult population}} \end{aligned} \]

Natural rate of unemployment: The normal rate of unemployment around which the unemployment rate fluctuates

Cyclical unemployment: the deviation of unemployment from its natural rate

3.2 Problems of Unemployment Rate

• Excludes discouraged workers: individuals who would like to work but have given up looking for a job
• Not distinguishes full-time job and part-time job (may be taken by people who cannot find a full-time job)
• Some people may lie to the Bureau of Labor Statistics

3.3 Why there are always some people unemployed

Frictional unemployment: unemployment that results because it takes time for workers to search for the jobs that best suit their tastes and skills

Structural unemployment: unemployment that results because the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants one

3.4 Public Policies

• Government can help to match the employees and employers

• Government can provide skills training for some laid off workers

• Unemployment insurance:

  • increases the amount of frictional unemployment

  • when workers turn down unattractive job offers, they have the opportunity to look for jobs that better suit their tastes and skills.

    Some economists argue that unemployment insurance improves the ability of the economy to match each worker with the most appropriate job.

3.5 Minimum-Wage Laws

↑ Structural unemployment

3.6 Unions and Collective Bargaining

Critics: inefficient and inequitable

unions raise wages above the level that would prevail in competitive markets

⇒ reduce the quantity of labor demanded ⇒ some workers to be unemployed

⇒ reduce the wages in the rest of the economy

Advocates:

the firm could use its market power to pay lower wages and offer worse working conditions than would prevail if it had to compete with other firms for the same workers

3.7 The Theory of Efficiency Wages

above-equilibrium wages paid by firms to increase worker productivity

• Worker Health
• Worker Turnover
• Worker Quality: attracts a better pool of workers to apply for its jobs and thereby increases the quality of its workforce
• Worker Effort: High wages make workers more eager to keep their jobs and thus motivate them to put forward their best effort (higher wages, higher supply, less job opportunities)

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Last update: September 13, 2022

Authors: Co1lin