Mankiw Principles of Economics (3rd ed)

Figur e 24-2

THE GROWTH IN REAL GDP

PER PERSON. This figure shows the average growth rate of real GDP per person for 16 advanced economies, including the major countries of Europe, Canada, the United States, Japan, and Australia. Notice that the growth rate rose substantially after 1950 and then fell after 1970.

SOURCE: Robert J. Barro and Xavier Sala-i- Martin, Economic Growth (New York: McGraw-Hill, 1995), p. 6.

IN THE NEWS

A Solution to

Africa’s Problems

with the IMF, the World Bank, donors, and creditors.

What a shame. So many good ideas, so few results. Output per head fell 0.7 percent between 1978 and 1987, and 0.6 percent during 1987–1994. Some growth is estimated for 1995 but only at 0.6 percent—far below the fastergrowing developing countries. . . .

The IMF and World Bank would be absolved of shared responsibility for slow growth if Africa were structurally incapable of growth rates seen in other parts of the world or if the continent’s low growth were an impenetrable mystery. But Africa’s growth rates are not huge mysteries. The evidence on cross-country growth suggests that Africa’s chronically low growth can be explained by standard economic variables linked to identifiable (and remediable) policies. . . .

Studies of cross-country growth show that per capita growth is related to:

• the initial income level of the country, with poorer countries tending to grow faster than richer countries;

•the extent of overall market orientation, including openness to trade, domestic market liberalization, private rather than state ownership, protection of private property rights, and low marginal tax rates;

•the national saving rate, which in turn is strongly affected by the government’s own saving rate; and

•the geographic and resource structure of the economy. . . .

These four factors can account broadly for Africa’s long-term growth predicament. While it should have grown faster than other developing areas because of relatively low income per head (and hence larger opportunity for “catch-up” growth), Africa grew more slowly. This was mainly because of much

higher trade barriers; excessive tax rates; lower saving rates; and adverse structural conditions, including an unusually high incidence of inaccessibility to the sea (15 of 53 countries are landlocked). . . .

If the policies are largely to blame, why, then, were they adopted? The historical origins of Africa’s antimarket orientation are not hard to discern. After almost a century of colonial depredations, African nations understandably if erroneously viewed open trade and foreign capital as a threat to national sovereignty. As in Sukarno’s Indonesia, Nehru’s India, and Peron’s Argentina, “self sufficiency” and “state leadership,” 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 economic 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 administration 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. Several 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 Africanbased 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 percent, as in the outward-oriented East Asian economies. . . .

Adam Smith spoke of a “tolerable” administration of justice, not perfect justice. Market liberalization is the primary key to strengthening the rule of law. Free trade, currency convertibility and automatic 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 public health and education, and monetary stability. . . .

All of this is possible only if the government 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, another 3 percent; public administration, 2 percent; the army and police, 3 percent. Government investment spending can be held to 5 percent of GDP but only if the private sector is invited to provide infrastructure in telecommunications, 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 marketing boards should be scrapped. Food and housing subsidies for urban workers cannot be financed. And, notably, interest 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 conjunction with far-reaching domestic reforms.

Source: Economist, June 29, 1996, pp. 19–21.

Summar y

Economic prosperity, as measured varies substantially around the income in the world’s richest times that in the world’s poorest growth rates of real GDP also relative positions of countries over time.

The standard of living in an economy’s ability to produce Productivity, in turn, depends physical capital, human capital, technological knowledge available

Government policies can influence growth rate in many ways: investment, encouraging investment

Key Concepts

maintaining property rights and allowing free trade, controlling

and promoting the research and technologies.

capital is subject to diminishing capital an economy has, the less the economy gets from an extra unit

of diminishing returns, higher saving for a period of time, but growth

down as the economy approaches a productivity, and income. Also returns, the return to capital is poor countries. Other things equal, grow faster because of the catch-up

1.What does the level of a nation’s does the growth rate of GDP rather live in a nation with a high low growth rate, or in a nation high growth rate?

2.List and describe four determinants

3.In what way is a college degree

4.Explain how higher saving leads living. What might deter a

raise the rate of saving?

of saving lead to higher growth indefinitely?

a trade restriction, such as a tariff, economic growth?

of population growth influence the person?

in which the U.S. government tries in technological knowledge.

Problems and Applications

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

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?

S A V I N G , I N V E S T M E N T , A N D

T H E F I N A N C I A L S Y S T E M

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 entrepreneurs, 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.

IN THIS CHAPTER YOU WILL . . .

Learn about some of the impor tant financial institutions in the U . S . economy

Consider how the financial system is r elated to key macr oeconomic variables

Develop a model of the supply and demand for loanable funds in financial markets

Use the loanable - funds model to analyze various government policies

Consider how government budget deficits af fect the U . S . economy

financial system

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

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 interest for the use of the money. Alternatively, you could convince someone to provide 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 investment 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 order 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. Second, 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, society’s allocation of scarce resources.

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 important 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 borrow 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 matures. 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 principal is never repaid.) The interest rate on a bond depends, in part, on its term. Longterm 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. Because 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 interest 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