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PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

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Page 1: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

PRODUCTION and

GROWTHMankiw, Chapter 25

Krugman, Chapter 25

Page 2: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Comparing Economies Across Time and Space

*Krugman

Page 3: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

U.S. Real GDP per Capita

Page 4: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

Income Around the World

Page 5: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

Rule of 70

The Rule of 70 tells us that the time it takes a variable that grows gradually over time to double is approximately 70 divided by that variable’s annual growth rate.

Page 6: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

Average Annual Growth Rates of Real GDP per Capita, 1975–2003

Page 7: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

The Sources of Long-Run Growth- Definitions:

Labor productivity

Physical capital

Human capital

Technology

Page 8: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Productivity plays a key role in determining living standards for all nations in the world.

*Productivity*Productivity refers to the amount of goods and services produced for each hour of a worker’s time.

*A nation’s standard of living is determined by the productivity of its workers

*Living standards, as measured by real GDP per person, vary significantly among nations

The poorest countries have average levels of income

that have not been seen in the United States for many

decades.

*Annual growth rates that seem small become large when compounded for many years.

*Compounding refers to the accumulation of a growth rate over a period of time.

Page 9: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Economists often use a PRODUCTION FUNCTIONPRODUCTION FUNCTION to describe the relationship between the quantity of inputs

used in production and the quantity of output from production.

Y = A F(L, K, H, N) – Y = quantity of output– A = available production technology– L = quantity of labor– K = quantity of physical capital– H = quantity of human capital– N = quantity of natural resources– F( ) is a function that shows how the inputs are

combined.

A production function has constant returns to scale if, for any positive number x,

xY = A F(xL, xK, xH, xN)xY = A F(xL, xK, xH, xN)

That is, a doubling of all inputs causes the amount of output to double as well.

Page 10: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

The preceding equation says that productivity (Y/L) depends on physical capital per worker

(K/L), human capital per worker (H/L), and natural resources per worker (N/L), as well as the

state of technology, (A).

Production functions with constant returns to scale have an interesting implication.

•Setting x = 1/L,•Y/ L = A F(1, K/ L, H/ L, N/ L)Y/ L = A F(1, K/ L, H/ L, N/ L)

Where:

Y/L = output per worker

K/L = physical capital per worker

H/L = human capital per worker

N/L = natural resources per worker

Page 11: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

Accounting for Growth: The Aggregate Production Function

The aggregate production function is a hypothetical function that shows how productivity (real GDP per worker) depends on the quantities of physical capital per worker and human capital per worker as well as the state of technology.

Page 12: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

Physical Capital and Productivity

Page 13: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Average GDP Per PersonAverage GDP Per Person grows about 2% per year.

This means Average GDP Per Person doubles every 35 years.

Page 14: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

Technological Progress and Productivity Growth

Page 15: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

One way to raise future productivity is

to invest more current resources in the production

of capital.

Government Policies That Raise Productivity and Living Standards

•Encourage saving and investment.•Encourage investment from abroad•Encourage education and training.•Establish secure property rights and maintain political stability.•Promote free trade.•Promote research and development•Condition of the infrastructure.

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Page 16: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

The catch-up effectcatch-up effect refers to the property

whereby countries that start off poor tend to

grow more rapidly than countries that start off

rich.

*As the stock of capital rises, the extra output produced from an additional unit of capital falls; this property is called diminishing returns.

*Because of diminishing returns, an increase in the saving rate leads to higher growth only for a while.

Encourage saving and investment

In short, a higher savings rate In short, a higher savings rate increasesincreases productivity.productivity.

Page 17: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Encourage investment from abroad

A capital investment that is owned and operated by a foreign entity is called foreign direct investment. (Ford Motor might build a car factory in Mexico) An investment that is financed with

foreign money but operated by domestic residents is called foreign portfolio investment. (An American might buy stock in a Mexican corporation)

In both cases, Americans provide the resources necessary to increase the

stock of capital in Mexico.

Page 18: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Encourage investment from abroad

When foreigners invest in a country, they expect a return on that investment.

When Ford’s car factory increases capital stock, it also increases the Mexican productivity and Mexican

GDP. Ford can then take some of this additional income back to the U.S. in the form of profit.

Remember that GDP is income earned within a country by residents and nonresidents,

whereas GNP is income earned by residents both at home and abroad.

Therefore, foreign investment in Mexico raises foreign investment in Mexico raises the income of Mexicans (GNP) by less than it the income of Mexicans (GNP) by less than it

raises the production in Mexico (GDP)raises the production in Mexico (GDP)

Page 19: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

An educated person might generate new new ideasideas about how best to produce goods and services, which in turn, might enter

society’s pool of knowledge and provide an external benefitexternal benefit to others.

For a country’s long-run growth, education is at least as important as investment in physical capital.

*In the United States, each year of schooling raises a person’s wage, on average, by about 10

percent.

*Thus, one way the government can enhance the standard of living is to provide schoolsprovide schools and

encourage the population to take advantage of them.

Encourage education and training

Page 20: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

EDUCATION is a positive externality.

One problem facing poor countries is the brain drain --the emigration of highly educated workers to rich countries. If human capital does

have positive externalities, then this brain drain makes those people left behind poorer than they otherwise would be….

Dilemma: Wouldn’t students from poor countries want to go to U.S. or other rich countries

for education?

What happens when they get there and they don’t want to

go back?

Encourage education and training

Page 21: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

In many developing countries contracts are difficult to enforce, and fraud goes

unpunished. Doing business in these countries means that

bribes and corruption are expected. This discourages international investment and

domestic savings.

Establish secure property rights and maintain political stability

Important for the price system to work is an economy-wide respect for property rights…. the ability for people to exercise authority over resources they own. It is VERY important that the government enforce property rights in a free market society.

Page 22: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Encourage Free Trade

Some of the poorest countries have tried to gain economic growth by using inward-oriented policies…….aimed at raising the living standards by avoiding interaction with the world.

Most economists, however, prefer the use of outward-oriented policies…. Through the elimination of trade barriers. Using another country’s technology and trading your goods for theirs acts as if the technology were in your own country.

Page 23: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

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Promote Research and Development

Technology improves our standard of living: telephone, microwave oven, computer, and the automobile, all serve to improve the quality of life we enjoy.

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Page 24: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Condition of Infrastructure

Infrastructure refers to bridges, roads, ports, power plants….the foundation for our economy.

A power grid that frequently shuts off electricity to homes and businesses or drought conditions because the dams can’t hold enough water to get through the dry season are both examples of poor infrastructure.

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are needed to see this picture.

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are needed to see this picture.

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are needed to see this picture.

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Page 25: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

Poor Countries Regulate Business the Most…

Page 26: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

Success, Disappointment, and Failure

Page 27: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

Success, Disappointment, and Failure

East Asian economies have done many things right and achieved very high growth rates.

In Latin America, where some important conditions are lacking, growth has generally been disappointing.

In Africa, real GDP per capita has declined for several decades, although there are some signs of progress now.

The convergence hypothesis fits the data only when factors that affect growth, such as education, infrastructure, and favorable policies and institutions, are held equal across countries.

Page 28: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

Economics in Action: Are economies converging?

Page 29: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

SAVING AND SAVING AND INVESTMENT IN THE INVESTMENT IN THE NATIONAL INCOME NATIONAL INCOME

ACCOUNTSACCOUNTS

Taken from Mankiw Ch 26

Krugman Ch 26

Page 30: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

The Savings–Investment Spending Identity in a Closed Economy

In a closed economy: GDP = C + I + G

SPrivate = GDP + TR − T − C

SGovernment = T − TR − G

NS = SPrivate + SGovernment = (GDP + TR − T − C) + (T − TR − G)

= GDP − C − G

Hence, I = NS

Investment spending = National savings in a closed economy

Page 31: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Recall that GDP is both total income in an economy and total expenditure on the economy’s output of goods and services:

Y = C + I + G + NY = C + I + G + NXX

Page 32: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Some Important IdentitiesSome Important Identities

• Assume a closed economyclosed economy – one that does not engage in international trade:

Y = C + I + GY = C + I + G

Page 33: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Some Important IdentitiesSome Important Identities

• Now, subtract C and G from both sides of the equation:

Y – C – G =IY – C – G =I• The left side of the equation is the total

income in the economy after paying for consumption and government purchases and is called national saving, or just saving (S).

Page 34: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Some Important IdentitiesSome Important Identities

• Substituting S for Y - C - G, the equation can be written as:

S = IS = I

Page 35: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Some Important IdentitiesSome Important Identities

• National saving, or saving, is equal to:

S = IS = I

S = Y – C – G S = Y – C – G

S = (Y – T – C) + (T – G)S = (Y – T – C) + (T – G)

Page 36: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

The Meaning of Saving and The Meaning of Saving and InvestmentInvestment

• National Saving– National saving is the total income in the

economy that remains after paying for consumption and government purchases.

• Private Saving– Private saving is the amount of income that

households have left after paying their taxes and paying for their consumption.

Private saving = (Y – T – C)Private saving = (Y – T – C)

Page 37: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

The Meaning of Saving and The Meaning of Saving and InvestmentInvestment

• Public Saving– Public saving is the amount of tax revenue

that the government has left after paying for its spending.

Public saving = (T – G)Public saving = (T – G)

Page 38: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

The Meaning of Saving and The Meaning of Saving and InvestmentInvestment

• Surplus and Deficit– If T > G, the government runs a budget

surplus because it receives more money than it spends.

– The surplus of T - G represents public saving.

– If G > T, the government runs a budget deficit because it spends more money than it receives in tax revenue.

Page 39: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

The Meaning of Saving and The Meaning of Saving and InvestmentInvestment

• For the economy as a whole, saving must be equal to investment.

S = IS = I

Page 40: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

Budget Surplus and Budget Deficit

Page 41: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

The Savings–Investment Spending Identity in an Open Economy

I = SPrivate + SGovernment + (IM – X) = NS + KI(10)

Investment spending = National savings + Capital inflow in an open economy

Page 42: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

The Savings-Investment Spending Identity in Open Economies: the United States and

Japan 2003

Page 43: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

THE MARKET FOR LOANABLE FUNDS

• Financial markets coordinate the economy’s saving and investment in the market for loanable funds.market for loanable funds.

Page 44: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

THE MARKET FOR LOANABLE FUNDS

• The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds.

Page 45: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

THE MARKET FOR LOANABLE FUNDS

• Loanable fundsLoanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption.

Page 46: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Supply and Demand for Loanable Supply and Demand for Loanable FundsFunds

• The supply of loanable funds comes from people who have extra income they want to save and lend out.

• The demand for loanable funds comes from households and firms that wish to borrow to make investments.

Page 47: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Supply and Demand for Loanable Supply and Demand for Loanable FundsFunds

• The interest rate is the price of the loan.

• It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving.

• The interest rate in the market for loanable funds is the real interest rate.

Page 48: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Supply and Demand for Loanable Supply and Demand for Loanable FundsFunds

• Financial markets work much like other markets in the economy.– The equilibrium of the supply and demand

for loanable funds determines the real interest rate.

Page 49: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Supply and Demand for Loanable Supply and Demand for Loanable FundsFunds

• Government Policies That Affect Saving and Investment– Taxes and saving– Taxes and investment– Government budget deficits

*Mankiw

Page 50: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

The Demand for Loanable Funds

Page 51: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

The Supply for Loanable Funds

Page 52: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

The Market for Loanable Funds

Loanable Funds(in billions of dollars)

0

InterestRate Supply

Demand

5%

$1,200

Copyright©2004 South-Western*Mankiw

Page 53: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

Equilibrium in the Loanable Funds Market

Page 54: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

Savings, Investment Spending, and Government Policy

Page 55: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

Increasing Private Savings

Page 56: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Policy 1: Saving IncentivesPolicy 1: Saving Incentives

• Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save.

Page 57: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Policy 1: Saving IncentivesPolicy 1: Saving Incentives

• A tax decrease increases the incentive for households to save at any given interest rate. – The supply of loanable funds curve shifts

to the right.– The equilibrium interest rate decreases.– The quantity demanded for loanable funds

increases.

Page 58: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

An Increase in the Supply of Loanable Funds

Loanable Funds(in billions of dollars)

0

InterestRate

Supply, S1 S2

2. . . . whichreduces theequilibriuminterest rate . . .

3. . . . and raises the equilibriumquantity of loanable funds.

Demand

1. Tax incentives forsaving increase thesupply of loanablefunds . . .

5%

$1,200

4%

$1,600

Copyright©2004 South-Western

Page 59: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Policy 1: Saving IncentivesPolicy 1: Saving Incentives

• If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment.

Page 60: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Policy 2: Investment IncentivesPolicy 2: Investment Incentives

• An investment tax credit increases the incentive to borrow.– Increases the demand for loanable funds.– Shifts the demand curve to the right.– Results in a higher interest rate and a

greater quantity saved.

Page 61: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Policy 2: Investment IncentivesPolicy 2: Investment Incentives

• If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving.

Page 62: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

An Increase in the Demand for Loanable Funds

Loanable Funds(in billions of dollars)

0

InterestRate

1. An investmenttax creditincreases thedemand for loanable funds . . .

2. . . . whichraises theequilibriuminterest rate . . .

3. . . . and raises the equilibriumquantity of loanable funds.

Supply

Demand, D1

D2

5%

$1,200

6%

$1,400

Copyright©2004 South-Western

Page 63: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Policy 3: Government Budget Policy 3: Government Budget Deficits and SurplusesDeficits and Surpluses

• When the government spends more than it receives in tax revenues, the short fall is called the budget deficit.

• The accumulation of past budget deficits is called the government debt.

Page 64: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Policy 3: Government Budget Policy 3: Government Budget Deficits and SurplusesDeficits and Surpluses

• Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by households and firms.

• This fall in investment is referred to as crowding out.– The deficit borrowing crowds out private

borrowers who are trying to finance investments.

Page 65: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Policy 3: Government Budget Policy 3: Government Budget Deficits and SurplusesDeficits and Surpluses

• A budget deficit decreases the supply of loanable funds. – Shifts the supply curve to the left. – Increases the equilibrium interest rate.– Reduces the equilibrium quantity of

loanable funds.

Page 66: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

The Effect of a Government Budget Deficit

Loanable Funds(in billions of dollars)

0

InterestRate

3. . . . and reduces the equilibriumquantity of loanable funds.

S2

2. . . . whichraises theequilibriuminterest rate . . .

Supply, S1

Demand

$1,200

5%

$800

6% 1. A budget deficitdecreases thesupply of loanablefunds . . .

Copyright©2004 South-Western

Page 67: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Policy 3: Government Budget Policy 3: Government Budget Deficits and SurplusesDeficits and Surpluses

• When government reduces national saving by running a deficit, the interest rate rises and investment falls.

Page 68: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Policy 3: Government Budget Policy 3: Government Budget Deficits and SurplusesDeficits and Surpluses

• A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment.

Page 69: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

The U.S. Government Debt

Percentof GDP

1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990

RevolutionaryWar

2010

CivilWar World War I

World War II

0

20

40

60

80

100

120

Copyright©2004 South-Western

Page 70: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

The Financial System - Definitions

Wealth Financial asset Physical asset Liability Transaction costs Financial risk

Page 71: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

Risk-Averse Attitudes Toward Gain and Loss

Page 72: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

Three Tasks of a Financial System

Reducing transaction costs Reducing financial risk Providing liquid assets

Page 73: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Financial Intermediaries Mutual funds

Pension funds

Life insurance companies

BanksFinancial Fluctuations

Financial market fluctuations can be a source of macroeconomic instability.

Are markets irrational?

Policy makers assume neither that markets always behave rationally nor that they can outsmart them.

*Krugman

Page 74: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

*Krugman

Page 75: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Summary

• The U.S. financial system is made up of financial institutions such as the bond market, the stock market, banks, and mutual funds.

• All these institutions act to direct the resources of households who want to save some of their income into the hands of households and firms who want to borrow.

Page 76: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Summary

• National income accounting identities reveal some important relationships among macroeconomic variables.

• In particular, in a closed economy, national saving must equal investment.

• Financial institutions attempt to match one person’s saving with another person’s investment.

Page 77: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Summary

• The interest rate is determined by the supply and demand for loanable funds.

• The supply of loanable funds comes from households who want to save some of their income.

• The demand for loanable funds comes from households and firms who want to borrow for investment.

Page 78: PRODUCTION and GROWTH Mankiw, Chapter 25 Krugman, Chapter 25

Summary

• National saving equals private saving plus public saving.

• A government budget deficit represents negative public saving and, therefore, reduces national saving and the supply of loanable funds.

• When a government budget deficit crowds out investment, it reduces the growth of productivity and GDP.