Economic growth occurs-technology improves or capital per hour worked increases

Financial System: the system of financial intermediates through which firms acquire funds from
households.
Financial Markets: markets where financial securities, such as stocks and bonds, are bought and sold.
A financial security is a document that states the terms under which funds pass from the buyer of a
security to a seller
Stock: a financial security that represents partial ownership of a firm
Firms can raise funds by selling shares of stock in a primary market.
The original buyers of stocks may resell them in a secondary market, where most daily trading takes
place.
Bond: A Financial security that represents a promise to repay a fixed amount of funds (seller promises to
pay buyer back plus interest)
firms and government running budget deficits can borrow funds by selling bonds in a primary market
Bonds are bought for the resale value plus interest
Financial intermediaries: Firms, such as banks, mutual funds, pension funds, and insurance companies
that borrow funds from savers and lend them to borrowers.
A closed economy does not engage in international trade of goods and services or in international
borrowing and lending, while an open economy does.
Saving has two components, private saving and public saving
Private saving is equal to what households retain of their income after purchasing goods(C) and services,
and paying taxes(T)
S
private
=Y+TR-C-T
Households receive income from supplying the factors of production to firms, and from transfer payments
from the government
Public saving is equal to what the government retains of its tax revenue(T) after purchasing goods and
services(G) and making transfer payments(TR)
S
public
=T-G-TR
When the government spends less than it collects in taxes, there is a budget surplus.
Savings=investment in a closed economy
Market for Loanable Funds: the interaction of borrowers and lenders that determines the market interest
rate and the quantity of loanable funds exchanged.
The quantity of loanable funds is the real interest rate because it reflects the true cost of borrowing and
the true return of lending
Demand for loanable funds comes from the firms that want to borrow for investment.
Holding all else constant, the quantity of loanable funds supplied increases as the real interest rate
increases and vice versa, so the supply of loanable funds slopes upward.
A surplus of loanable funds causes lenders to compete for borrowers, driving the real interest rate down,
while a shortage of loanable funds gives lenders an incentive to raise the real interest rate.
At the equilibrium real interest rate(I) the quantity of loanable funds demanded equals the quantity
supplied.
S=I at L*
L* is the quantity of saving and investment that actually occurs in the economy
When L* increases, the economys capital per hour worked increases and or technology improves, so the
economys productivity and standard of living increase.
The government can encourage an increase in the economys L* by:
Increasing households incentive to save(by lowering the tax rate on interest income, by
switching from taxing nominal interest to taxing real interest, or by switching from an income tax
to a consumption tax)
Increasing firms incentive to invest(by providing tax credits for investing)
Reducing or eliminating a government budget deficit(a government budget deficit decreases the
economys total saving and, therefore decreses L*, crowding out investment)
Over time the US economy has experienced economic growth and economic recession but it has not been
constant
The Us economy has experienced the
Business Cycle: alternating periods of economic expansion and recession
Expansion: the period of a business cycle during which total production and total employment are
increasing
Recession: the period of a business cycle during which total production and total employment ate
decreasing
Business cycles are irregular and unpredictable: the lengths of the expansion and recession phases and
which sectors of the economy are most affected are different during each business cycle
However certain statistical series known as leading economic indicators tend to begin to turn upward or
downward before the overall economy does
One important leasing economic indicator is stock indexes, which are averages of stock prices
Dow Jones Industrial Average 30 large US Firms
S&P 500 500 large firms
NASDAQ is >3000 firms, mainly high tech
A Recession typically begins with a decline in spending by firms on capital goods and by households on
consumer durables.
Near the end of a recession, the inflation rate usually falls in response to weak demand for consumer
goods, stock prices usually continue to fall in response to pessimism, and the interest rate usually falls in
response to weak demand for investment
At some point savers decrease their purchases of bonds because their interest rates are low and increase
their purchases of stocks because their prices are low.
The increase in demand for stocks causes the upward movement in stock prices that usually begins before
an expansion begins (this is why stock indexes are a leading economic indicator)
The lower interest rate gives both firms and households an incentive to borrow to finance new spending
An increase in spending by firms on capital goods and by households on consumer durables ends the
recession and begins the expansion
The resulting increase in sales causes firms to increase production and employment, though the
unemployment rate does not decrease until the latter part of an expansion because
Firms increase the hours of their existing workforce, some of whom are unemployed, before they
hire new workers
Discouraged workers often return to the labor force during an expansion
Rising profits and, eventually, falling unemployment increase income, causing further increases in
spending
Near the end of an expansion, the inflation rate usually rises in response to strong demand for consumer
goods, stock prices usually continue to rise in response to strong demand for investment.
At some point, savers decrease their purchases of stocks because their prices are high and increase their
purchases of bonds because their interest rates are high.
The decrease in demand for stocks causes the downward movement in stock prices that usually begins
before a recession begins
The higher interest rate gives both firms and households an incentive to stop borrowing to finance new
spending.
This leads to the decline in spending by firms on capital goods and by households on consumer durables
that ends the expansion and begins the next recession