CHAPTER 24 PRODUCTION AND GROWTH 549 especially important for technological progress. There is no doubt that these issues are among the most important in economics. The success of one generation’s poli- cymakers in learning and heeding the fundamental lessons about economic growth determines what kind of world the next generation will inherit. higher trade barriers; excessive tax rates; lower saving rates; and adverse structural conditions, including an unusu- ally high incidence of inaccessibility to the sea (15 of 53 countries are land- locked). . . . If the policies are largely to blame, why, then, were they adopted? The his- torical origins of Africa’s antimarket ori- entation are not hard to discern. After almost a century of colonial depreda- tions, African nations understandably if erroneously viewed open trade and for- eign capital as a threat to national sover- eignty. As in Sukarno’s Indonesia, Nehru’s India, and Peron’s Argentina, “self sufficiency” and “state leader- ship,” including state ownership of much of industry, became the guideposts of the economy. As a result, most of Africa went into a largely self-imposed eco- nomic exile. . . . Adam Smith in 1755 famously remarked that “little else is requisite to carry a state to the highest degrees of opulence from the lowest barbarism, but peace, easy taxes, and tolerable admin- istration of justice.” A growth agenda need not be long and complex. Take his points in turn. Peace, of course, is not so easily guaranteed, but the conditions for peace on the continent are better than today’s ghastly headlines would suggest. Sev- eral of the large-scale conflicts that have ravaged the continent are over or nearly so. . . . The ongoing disasters, such as in Liberia, Rwanda and Somalia, would be better contained if the West were willing to provide modest support to African- based peacekeeping efforts. “Easy taxes” are well within the ambit of the IMF and World Bank. But here, the IMF stands guilty of neglect, if not malfeasance. African nations need simple, low taxes, with modest revenue targets as a share of GDP. Easy taxes are most essential in international trade, since successful growth will depend, more than anything else, on economic integration with the rest of the world. Africa’s largely self-imposed exile from world markets can end quickly by cutting import tariffs and ending export taxes on agricultural exports. Corporate tax rates should be cut from rates of 40 percent and higher now prevalent in Africa, to rates between 20 percent and 30 per- cent, as in the outward-oriented East Asian economies. . . . Adam Smith spoke of a “tolerable” administration of justice, not perfect jus- tice. Market liberalization is the primary key to strengthening the rule of law. Free trade, currency convertibility and auto- matic incorporation of business vastly reduce the scope for official corruption and allow the government to focus on the real public goods—internal public order, the judicial system, basic pub- lic health and education, and monetary stability. . . . All of this is possible only if the gov- ernment itself has held its own spending to the necessary minimum. The Asian economies show how to function with government spending of 20 percent of GDP or less (China gets by with just 13 percent). Education can usefully absorb around 5 percent of GDP; health, an- other 3 percent; public administration, 2 percent; the army and police, 3 per- cent. Government investment spending can be held to 5 percent of GDP but only if the private sector is invited to pro- vide infrastructure in telecommunica- tions, port facilities, and power. . . . This fiscal agenda excludes many popular areas for government spending. There is little room for transfers or social spending beyond education and health (though on my proposals, these would get a hefty 8 percent of GDP). Subsidies to publicly owned companies or market- ing boards should be scrapped. Food and housing subsidies for urban workers cannot be financed. And, notably, inter- est payments on foreign debt are not budgeted for. This is because most bankrupt African states need a fresh start based on deep debt-reduction, which should be implemented in con- junction with far-reaching domestic reforms. Source: Economist, June 29, 1996, pp. 19–21. 550 PART NINE THE REAL ECONOMY IN THE LONG RUN ◆ Economic prosperity, as measured by GDP per person, varies substantially around the world. The average income in the world’s richest countries is more than ten times that in the world’s poorest countries. Because growth rates of real GDP also vary substantially, the relative positions of countries can change dramatically over time. ◆ The standard of living in an economy depends on the economy’s ability to produce goods and services. Productivity, in turn, depends on the amounts of physical capital, human capital, natural resources, and technological knowledge available to workers. ◆ Government policies can influence the economy’s growth rate in many ways: encouraging saving and investment, encouraging investment from abroad, fostering education, maintaining property rights and political stability, allowing free trade, controlling population growth, and promoting the research and development of new technologies. ◆ The accumulation of capital is subject to diminishing returns: The more capital an economy has, the less additional output the economy gets from an extra unit of capital. Because of diminishing returns, higher saving leads to higher growth for a period of time, but growth eventually slows down as the economy approaches a higher level of capital, productivity, and income. Also because of diminishing returns, the return to capital is especially high in poor countries. Other things equal, these countries can grow faster because of the catch-up effect. Summary productivity, p. 533 physical capital, p. 534 human capital, p. 534 natural resources, p. 534 technological knowledge, p. 535 diminishing returns, p. 539 catch-up effect, p. 539 Key Concepts 1. What does the level of a nation’s GDP measure? What does the growth rate of GDP measure? Would you rather live in a nation with a high level of GDP and a low growth rate, or in a nation with a low level and a high growth rate? 2. List and describe four determinants of productivity. 3. In what way is a college degree a form of capital? 4. Explain how higher saving leads to a higher standard of living. What might deter a policymaker from trying to raise the rate of saving? 5. Does a higher rate of saving lead to higher growth temporarily or indefinitely? 6. Why would removing a trade restriction, such as a tariff, lead to more rapid economic growth? 7. How does the rate of population growth influence the level of GDP per person? 8. Describe two ways in which the U.S. government tries to encourage advances in technological knowledge. Questions for Review 1. Most countries, including the United States, import substantial amounts of goods and services from other countries. Yet the chapter says that a nation can enjoy a high standard of living only if it can produce a large quantity of goods and services itself. Can you reconcile these two facts? 2. List the capital inputs necessary to produce each of the following: a. cars b. high school educations c. plane travel d. fruits and vegetables Problems and Applications CHAPTER 24 PRODUCTION AND GROWTH 551 3. U.S. income per person today is roughly eight times what it was a century ago. Many other countries have also experienced significant growth over that period. What are some specific ways in which your standard of living differs from that of your great-grandparents? 4. The chapter discusses how employment has declined relative to output in the farm sector. Can you think of another sector of the economy where the same phenomenon has occurred more recently? Would you consider the change in employment in this sector to represent a success or a failure from the standpoint of society as a whole? 5. Suppose that society decided to reduce consumption and increase investment. a. How would this change affect economic growth? b. What groups in society would benefit from this change? What groups might be hurt? 6. Societies choose what share of their resources to devote to consumption and what share to devote to investment. Some of these decisions involve private spending; others involve government spending. a. Describe some forms of private spending that represent consumption, and some forms that represent investment. b. Describe some forms of government spending that represent consumption, and some forms that represent investment. 7. What is the opportunity cost of investing in capital? Do you think a country can “over-invest” in capital? What is the opportunity cost of investing in human capital? Do you think a country can “over-invest” in human capital? Explain. 8. Suppose that an auto company owned entirely by German citizens opens a new factory in South Carolina. a. What sort of foreign investment would this represent? b. What would be the effect of this investment on U.S. GDP? Would the effect on U.S. GNP be larger or smaller? 9. In the 1980s Japanese investors made significant direct and portfolio investments in the United States. At the time, many Americans were unhappy that this investment was occurring. a. In what way was it better for the United States to receive this Japanese investment than not to receive it? b. In what way would it have been better still for Americans to have done this investment? 10. In the countries of South Asia in 1992, only 56 young women were enrolled in secondary school for every 100 young men. Describe several ways in which greater educational opportunities for young women could lead to faster economic growth in these countries. 11. International data show a positive correlation between political stability and economic growth. a. Through what mechanism could political stability lead to strong economic growth? b. Through what mechanism could strong economic growth lead to political stability? IN THIS CHAPTER YOU WILL . . . Consider how government budget deficits affect the U.S. economy Develop a model of the supply and demand for loanable funds in financial markets Learn about some of the important financial institutions in the U.S. economy Consider how the financial system is related to key macroeconomic variables Use the loanable- funds model to analyze various government policies Imagine that you have just graduated from college (with a degree in economics, of course) and you decide to start your own business—an economic forecasting firm. Before you make any money selling your forecasts, you have to incur substantial costs to set up your business. You have to buy computers with which to make your forecasts, as well as desks, chairs, and filing cabinets to furnish your new office. Each of these items is a type of capital that your firm will use to produce and sell its services. How do you obtain the funds to invest in these capital goods? Perhaps you are able to pay for them out of your past savings. More likely, however, like most en- trepreneurs, you do not have enough money of your own to finance the start of your business. As a result, you have to get the money you need from other sources. SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 553 554 PART NINE THE REAL ECONOMY IN THE LONG RUN There are various ways for you to finance these capital investments. You could borrow the money, perhaps from a bank or from a friend or relative. In this case, you would promise not only to return the money at a later date but also to pay in- terest for the use of the money. Alternatively, you could convince someone to pro- vide the money you need for your business in exchange for a share of your future profits, whatever they might happen to be. In either case, your invest- ment in computers and office equipment is being financed by someone else’s saving. The financial system consists of those institutions in the economy that help to match one person’s saving with another person’s investment. As we discussed in the previous chapter, saving and investment are key ingredients to long-run economic growth: When a country saves a large portion of its GDP, more resources are available for investment in capital, and higher capital raises a country’s productivity and living standard. The previous chapter, however, did not explain how the economy coordinates saving and investment. At any time, some people want to save some of their income for the future, and others want to borrow in or- der to finance investments in new and growing businesses. What brings these two groups of people together? What ensures that the supply of funds from those who want to save balances the demand for funds from those who want to invest? This chapter examines how the financial system works. First, we discuss the large variety of institutions that make up the financial system in our economy. Sec- ond, we discuss the relationship between the financial system and some key macroeconomic variables—notably saving and investment. Third, we develop a model of the supply and demand for funds in financial markets. In the model, the interest rate is the price that adjusts to balance supply and demand. The model shows how various government policies affect the interest rate and, thereby, soci- ety’s allocation of scarce resources. FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY At the broadest level, the financial system moves the economy’s scarce resources from savers (people who spend less than they earn) to borrowers (people who spend more than they earn). Savers save for various reasons—to put a child through college in several years or to retire comfortably in several decades. Simi- larly, borrowers borrow for various reasons—to buy a house in which to live or to start a business with which to make a living. Savers supply their money to the fi- nancial system with the expectation that they will get it back with interest at a later date. Borrowers demand money from the financial system with the knowledge that they will be required to pay it back with interest at a later date. The financial system is made up of various financial institutions that help co- ordinate savers and borrowers. As a prelude to analyzing the economic forces that drive the financial system, let’s discuss the most important of these institutions. Fi- nancial institutions can be grouped into two categories—financial markets and fi- nancial intermediaries. We consider each category in turn. financial system the group of institutions in the economy that help to match one person’s saving with another person’s investment CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 555 FINANCIAL MARKETS Financial markets are the institutions through which a person who wants to save can directly supply funds to a person who wants to borrow. The two most impor- tant financial markets in our economy are the bond market and the stock market. The Bond Market When Intel, the giant maker of computer chips, wants to borrow to finance construction of a new factory, it can borrow directly from the public. It does this by selling bonds. A bond is a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond. Put simply, a bond is an IOU. It identifies the time at which the loan will be repaid, called the date of maturity, and the rate of interest that will be paid periodically until the loan matures. The buyer of a bond gives his or her money to Intel in exchange for this promise of interest and eventual repayment of the amount borrowed (called the principal). The buyer can hold the bond until maturity or can sell the bond at an earlier date to someone else. There are literally millions of different bonds in the U.S. economy. When large corporations, the federal government, or state and local governments need to bor- row to finance the purchase of a new factory, a new jet fighter, or a new school, they usually do so by issuing bonds. If you look at The Wall Street Journal or the business section of your local newspaper, you will find a listing of the prices and interest rates on some of the most important bond issues. Although these bonds differ in many ways, three characteristics of bonds are most important. The first characteristic is a bond’s term—the length of time until the bond ma- tures. Some bonds have short terms, such as a few months, while others have terms as long as 30 years. (The British government has even issued a bond that never matures, called a perpetuity. This bond pays interest forever, but the princi- pal is never repaid.) The interest rate on a bond depends, in part, on its term. Long- term bonds are riskier than short-term bonds because holders of long-term bonds have to wait longer for repayment of principal. If a holder of a long-term bond needs his money earlier than the distant date of maturity, he has no choice but to sell the bond to someone else, perhaps at a reduced price. To compensate for this risk, long-term bonds usually pay higher interest rates than short-term bonds. The second important characteristic of a bond is its credit risk—the probability that the borrower will fail to pay some of the interest or principal. Such a failure to pay is called a default. Borrowers can (and sometimes do) default on their loans by declaring bankruptcy. When bond buyers perceive that the probability of default is high, they demand a higher interest rate to compensate them for this risk. Be- cause the U.S. government is considered a safe credit risk, government bonds tend to pay low interest rates. By contrast, financially shaky corporations raise money by issuing junk bonds, which pay very high interest rates. Buyers of bonds can judge credit risk by checking with various private agencies, such as Standard & Poor’s, which rate the credit risk of different bonds. The third important characteristic of a bond is its tax treatment—the way in which the tax laws treat the interest earned on the bond. The interest on most bonds is taxable income, so that the bond owner has to pay a portion of the inter- est in income taxes. By contrast, when state and local governments issue bonds, called municipal bonds, the bond owners are not required to pay federal income tax on the interest income. Because of this tax advantage, bonds issued by state and financial markets financial institutions through which savers can directly provide funds to borrowers bond a certificate of indebtedness 556 PART NINE THE REAL ECONOMY IN THE LONG RUN local governments pay a lower interest rate than bonds issued by corporations or the federal government. The Stock Market Another way for Intel to raise funds to build a new semiconductor factory is to sell stock in the company. Stock represents ownership in a firm and is, therefore, a claim to the profits that the firm makes. For example, if Intel sells a total of 1,000,000 shares of stock, then each share represents owner- ship of 1/1,000,000 of the business. The sale of stock to raise money is called equity finance, whereas the sale of bonds is called debt finance. Although corporations use both equity and debt fi- nance to raise money for new investments, stocks and bonds are very different. The owner of shares of Intel stock is a part owner of Intel; the owner of an Intel bond is a creditor of the corporation. If Intel is very profitable, the stockholders en- joy the benefits of these profits, whereas the bondholders get only the interest on their bonds. And if Intel runs into financial difficulty, the bondholders are paid what they are due before stockholders receive anything at all. Compared to bonds, stocks offer the holder both higher risk and potentially higher return. After a corporation issues stock by selling shares to the public, these shares trade among stockholders on organized stock exchanges. In these transactions, the corporation itself receives no money when its stock changes hands. The most im- portant stock exchanges in the U.S. economy are the New York Stock Exchange, the American Stock Exchange, and NASDAQ (National Association of Securities Dealers Automated Quotation system). Most of the world’s countries have their own stock exchanges on which the shares of local companies trade. The prices at which shares trade on stock exchanges are determined by the supply and demand for the stock in these companies. Because stock represents ownership in a corporation, the demand for a stock (and thus its price) reflects people’s perception of the corporation’s future profitability. When people become optimistic about a company’s future, they raise their demand for its stock and thereby bid up the price of a share of stock. Conversely, when people come to ex- pect a company to have little profit or even losses, the price of a share falls. Various stock indexes are available to monitor the overall level of stock prices. A stock index is computed as an average of a group of stock prices. The most fa- mous stock index is the Dow Jones Industrial Average, which has been computed regularly since 1896. It is now based on the prices of the stocks of 30 major U.S. companies, such as General Motors, General Electric, Microsoft, Coca-Cola, AT&T, and IBM. Another well-known stock index is the Standard & Poor’s 500 Index, which is based on the prices of 500 major companies. Because stock prices reflect expected profitability, these stock indexes are watched closely as possible indica- tors of future economic conditions. FINANCIAL INTERMEDIARIES Financial intermediaries are financial institutions through which savers can indi- rectly provide funds to borrowers. The term intermediary reflects the role of these institutions in standing between savers and borrowers. Here we consider two of the most important financial intermediaries—banks and mutual funds. stock a claim to partial ownership in a firm T HE N EW Y ORK S TOCK E XCHANGE financial intermediaries financial institutions through which savers can indirectly provide funds to borrowers CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 557 Banks If the owner of a small grocery store wants to finance an expansion of his business, he probably takes a strategy quite different from Intel. Unlike Intel, a small grocer Most daily newspapers include stock tables, which contain in- formation about recent trading in the stocks of several thou- sand companies. Here is the kind of information these ta- bles usually provide: ◆ Price. The single most im- portant piece of informa- tion about a stock is the price of a share. The newspaper usually pre- sents several prices. The “last” or “closing” price is the price of the last trans- action that occurred before the stock exchange closed the previous day. Many newspapers also give the “high” and “low” prices over the past day of trading and, sometimes, over the past year as well. ◆ Volume. Most newspapers present the number of shares sold during the past day of trading. This figure is called the daily volume. ◆ Dividend. Corporations pay out some of their profits to their stockholders; this amount is called the dividend. (Profits not paid out are called retained earnings and are used by the corporation for additional investment.) Newspapers often report the dividend paid over the pre- vious year for each share of stock. They sometimes report the dividend yield, which is the dividend ex- pressed as a percentage of the stock’s price. ◆ Price-earnings ratio. A corporation’s earnings, or profit, is the amount of revenue it receives for the sale of its products minus its costs of production as measured by its accountants. Earnings per share is the company’s total earnings divided by the number of shares of stock outstanding. Companies use some of their earnings to pay dividends to stockholders; the rest is kept in the firm to make new investments. The price–earnings ratio, often called the P/E, is the price of a corpora- tion’s stock divided by the amount the corporation earned per share over the past year. Historically, the typical price–earnings ratio is about 15. A higher P/E in- dicates that a corporation’s stock is expensive relative to its recent earnings; this might indicate either that people expect earnings to rise in the future or that the stock is overvalued. Conversely, a lower P/E indicates that a corporation’s stock is cheap relative to its recent earnings; this might indicate either that people expect earnings to fall or that the stock is under valued. Why does the newspaper repor t all these data every day? Many people who invest their savings in stock follow these numbers closely when deciding which stocks to buy and sell. By contrast, other stockholders follow a buy-and-hold strat- egy: They buy the stock of well-run companies, hold it for long periods of time, and do not respond to the daily fluctu- ations reported in the paper. Name of company Symbol for company’s stock 52 Weeks Hi Lo Stock Sym Div Yld % PE Vol 100s Hi Lo Close Net Chg 26 3 / 16 12 7 / 8 75 7 / 16 22 1 / 2 23 7 / 16 6 7 / 8 47 5 / 16 9 3 / 4 CslFnl Coastcast CocaCola CCFemsa ADR TOPrS PAR KO KOF 2.09 .64 .12e 8.6 . 1.3 .9 . 17 40 . 59 171 39384 2121 24 1 / 4 11 3 / 8 51 13 13 / 16 23 13 / 16 10 7 / 8 49 3 / 4 12 7 / 8 24 1 / 4 11 3 / 8 51 13 3 / 4 + 1 / 16 + 3 / 8 +1 1 / 16 + 1 / 16 Dividend amount Dividend yield Price– earnings ratio Trading volume over the previous day Highest and lowest price over the previous day Last price at which the stock traded Change in closing price from the day before Highest and lowest price of the stock over the past year FYI How to Read the Newspaper’s Stock Tables 558 PART NINE THE REAL ECONOMY IN THE LONG RUN would find it difficult to raise funds in the bond and stock markets. Most buyers of stocks and bonds prefer to buy those issued by larger, more familiar companies. The small grocer, therefore, most likely finances his business expansion with a loan from a local bank. Banks are the financial intermediaries with which people are most familiar. A primary job of banks is to take in deposits from people who want to save and use these deposits to make loans to people who want to borrow. Banks pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans. The difference between these rates of interest covers the banks’ costs and re- turns some profit to the owners of the banks. Besides being financial intermediaries, banks play a second important role in the economy: They facilitate purchases of goods and services by allowing people to write checks against their deposits. In other words, banks help create a special asset that people can use as a medium of exchange. A medium of exchange is an item that people can easily use to engage in transactions. A bank’s role in providing a medium of exchange distinguishes it from many other financial institutions. Stocks and bonds, like bank deposits, are a possible store of value for the wealth that people have accumulated in past saving, but access to this wealth is not as easy, cheap, and immediate as just writing a check. For now, we ignore this second role of banks, but we will return to it when we discuss the monetary system in Chapter 27. Mutual Funds A financial intermediary of increasing importance in the U.S. economy is the mutual fund. A mutual fund is an institution that sells shares to the public and uses the proceeds to buy a selection, or portfolio, of various types of stocks, bonds, or both stocks and bonds. The shareholder of the mutual fund ac- cepts all the risk and return associated with the portfolio. If the value of the port- folio rises, the shareholder benefits; if the value of the portfolio falls, the shareholder suffers the loss. The primary advantage of mutual funds is that they allow people with small amounts of money to diversify. Buyers of stocks and bonds are well advised to heed the adage: Don’t put all your eggs in one basket. Because the value of any single stock or bond is tied to the fortunes of one company, holding a single kind of stock or bond is very risky. By contrast, people who hold a diverse portfolio of stocks and bonds face less risk because they have only a small stake in each com- pany. Mutual funds make this diversification easy. With only a few hundred dol- lars, a person can buy shares in a mutual fund and, indirectly, become the part owner or creditor of hundreds of major companies. For this service, the company mutual fund an institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds . The owner of shares of Intel stock is a part owner of Intel; the owner of an Intel bond is a creditor of the corporation. If Intel is very profitable,. follow a buy-and-hold strat- egy: They buy the stock of well-run companies, hold it for long periods of time, and do not respond to the daily fluctu- ations