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consumer price index (CPI)
a measure of the overall
cost of the goods and
services bought by a
typical consumer

inflation rate
the percentage change in
the price index from the
preceding period

the automatic correction
by law or contract of a
core CPI dollar amount for the
a measure of the overall effects of inflation
cost of consumer goods
and services excluding nominal interest rate
food and energy the interest rate as
usually reported without a
producer price index correction for the effects
a measure of the cost of of inflation
a basket of goods and
services bought by firms real interest rate
the interest rate corrected
for the effects of inflation
GROWTH  Saving and Investment
 Diminishing Returns and Catch-up Effect
productivity  Investment from Abroad
the quantity of goods and  Education
services produced from
 Health and Nutrition
each unit of labor input
 Property Rights and Political Stability
physical capital  Free Trade
the stock of equipment  Research and Development
and structures that are  Population Growth
used to produce goods
and services Saving and Investment

human capital  one way to raise future productivity is

the knowledge and skills to
that workers acquire invest more current resources in the
through education, production of capital.
training, and experience  for society to invest more in capital, it
must consume less and save more of
natural resources its current income.
the inputs into the
 The growth that arises
production of goods and
services that are provided from capital accumulation is not a free
by nature, such as land, lunch: It requires that society sacrifice
rivers, and mineral consumption of goods and services in
deposits the present to enjoy higher
consumption in the future.
technological knowledge
society’s understanding of Diminishing Returns and Catch-up Effect
the best ways to produce
goods and services The traditional view of the production
process is that capital is subject to
diminishing returns diminishing returns:
the property whereby the
benefit from an extra unit As the stock of capital rises, the extra
of an input declines as output produced from an additional unit of
the quantity of the input capital falls.
In other words, when workers already
catch-up effect have a large quantity of capital to use in
the property whereby producing goods and services, giving
countries that start off them an additional unit of capital
poor tend to grow more increases their productivity only
rapidly than countries
that start off rich
As the higher saving rate allows more
capital to be accumulated, the benefits
from additional capital become smaller
over time, and so growth slows down. In
the long run, the higher saving rate leads
to a higher level of productivity and
income but not to higher growth in these
variables. Reaching this long run,
however, can take quite a while.

The property of diminishing returns to

capital has another important implication:
Other things being equal, it is easier for a another type of investment in people:
country to grow fast if it starts out expenditures that lead to a healthier
relatively poor. This effect of initial population.
conditions on subsequent growth is
sometimes called the catch-up effect. The causal link between health and wealth runs
in both directions. Poor countries are poor in
part because their populations are not healthy,
and their populations are not healthy in part
Investment from Abroad because they are poor and cannot afford
adequate healthcare and nutrition. It is a
A capital investment that is owned and
vicious circle. But this fact opens the possibility
operated by a foreign entity is called foreign
of a virtuous circle: Policies that lead to more
direct investment
rapid economic growth would naturally improve
An investment that is financed with foreign health outcomes, which in turn would further
money but operated by domestic residents is promote economic growth.
called foreign portfolio investment.

An organization that tries to encourage the

Property Rights and Political Stability
flow of capital to poor countries is the World
Bank. Production in market economies arises from
the interactions of millions of individuals and
Thus, every country has an interest in
promoting economic prosperity around the
world. The World Bank and the International To achieve this outcome, the economy has to
Monetary Fund were established to achieve coordinate transactions among these firms, as
that common goal well as between firms and consumers.
Education Market prices are the instrument with which
the invisible hand of the marketplace brings
Education—investment in human capital—is at
supply and demand into balance in each of the
least as important as investment in physical
many thousands of markets that make up the
capital for a country’s long-run economic
Property rights refer to the ability of people
One-way government policy can enhance the
to exercise authority over the resources they
standard of living is to provide good schools
and to encourage the population to take
advantage of them. One threat to property rights is political
Some economists have argued that human
capital is particularly important for economic  When revolutions and
growth because human capital conveys coups are common, there is doubt
positive externalities. An externality is the about whether property rights will be
effect of one person’s actions on the well-being respected
of a bystander. in the future. If a revolutionary
government might confiscate the
One problem facing some poor countries is the
capital of some
brain drain—the emigration of many of the
businesses, as was often true after
most highly educated workers to rich countries,
communist revolutions, domestic
where these workers can enjoy a higher
standard of living.
have less incentive to save, invest, and
If human capital does have positive start new businesses.
externalities, then this brain drain makes those
Thus, economic prosperity depends in part on
people left behind even poorer
political prosperity.
Health and Nutrition
Free Trade
The term human capital usually refers to
education, but it can also be used to describe
Some of the world’s poorest countries have between the sexes is necessary and will remain
tried to achieve more rapid economic growth nearly in its present state.” He concluded that
by pursuing inward-oriented policies “the power of population is infinitely greater
than the power in the earth to produce
These policies attempt to increase productivity subsistence for man.”
and living standards within the country by
avoiding interaction with the rest of the world. Diluting the Capital Stock

Most economists today believe that poor Whereas Malthus worried about the effects of
countries are better off pursuing outward- Thomas Robert Malthus population on the use
oriented policies that integrate these of natural resources, some modern theories of
countries into the world economy. economic growth emphasize its effects on
capital accumulation.
The adverse impact of inward orientation
becomes clear when one considers the small According to these theories, high population
size of many less developed economies. growth reduces GDP per worker because rapid
growth in the number of workers forces the
The amount that a nation trades with others is capital stock to be spread more thinly.
determined not only by government policy but
also by geography. Countries with natural In other words, when population growth is
seaports find trade easier than countries rapid, each worker is equipped with less
without this resource. capital. A smaller quantity of capital per worker
leads to lower productivity and lower GDP per
Research and Development worker.
To a large extent, knowledge is a public good: Promoting Technological Progress
That is, once one person discovers an idea, the
idea enters society’s pool of knowledge and Rapid population growth may depress
other people can freely use it. economic prosperity by reducing the amount of
capital each worker has, but it may also have
Yet another way in which government policy some benefits.
encourages research is through the patent
system. When a person or firm creates an The mechanism is simple: If there are more
innovative product, such as a new drug, the people, then there are more scientists,
inventor can apply for a patent. inventors, and engineers to contribute to
technological advance, which benefits
Population Growth everyone.
The most direct effect is on the size of the Economist Michael Kremer began by noting
labor force: A large population means more that over the broad span of human history,
workers to produce goods and services world growth rates have increased with world
A large population means more people to
consume those goods and services. So, while a Kremer’s second piece of evidence comes from
large population means a larger total output of comparing regions of the world.
goods and services, it need not mean a higher
standard of living for the typical citizen. Indeed, If technological progress is more rapid when
both large and small nations are found at all there are more people to discover things, then
levels of economic development. larger regions should have experienced more
rapid growth.
Stretching Natural Resources

Thomas Robert Malthus (1766–1834), an

English minister and early economic thinker.
Malthus argued that an ever-increasing
population would continually strain society’s
ability to provide for itself. As a result, mankind
was doomed to forever live in poverty.

He began by noting that “food is necessary to

the existence of man” and that “the passion
British government has even issued a bond
that never matures, called a perpetuity.

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

By contrast, financially shaky corporations

raise money by issuing junk bonds, which pay
very high interest rates.

The third important characteristic of a bond is

its tax treatment—the way the tax laws treat
the interest earned on the bond.

a claim to partial
ownership in a firm

The sale of stock to raise money is called

equity finance, whereas the sale of bonds is
called debt finance.

A stock index is computed as an average of a

group of stock prices. The most famous stock
index is the Dow Jones Industrial Average,
CHAPTER 13: SAVING, which has been computed regularly since

financial system
the group of institutions
in the economy that help financial intermediaries
to match one person’s financial institutions
saving with another through which savers can
person’s investment indirectly provide funds
to borrowers
financial markets
financial institutions The term intermediary reflects the role of
through which savers can these institutions in standing between savers
directly provide funds to and borrowers.
Two of the most important financial
The two most important financial markets in intermediaries: banks and mutual funds.
our economy are the bond market and the
stock market. Banks help create a special asset that people
can use as a medium of exchange. A
bond medium of exchange is an item that people can
a certificate of easily use to engage in transactions.
Stocks and bonds, like bank deposits, are a
Put simply, a bond is an IOU. It identifies the possible store of value for the wealth that
time at which the loan will be repaid, called the people have accumulated in past saving, but
date of maturity, and the rate of interest that access to this wealth is not as easy, cheap, and
will be paid periodically until the loan matures. immediate as just writing a check or swiping a
debit card.
The first characteristic is a bond’s term—the
length of time until the bond matures. The mutual fund
an institution that sells
shares to the public and Actual economies are open economies—that
uses the proceeds to buy is, they interact with other economies around
a portfolio of stocks and the world.
national saving (saving)
The primary advantage of mutual funds is that the total income in
they allow people with small amounts of money the economy that
to diversify their holdings. Buyers of stocks and remains after paying
bonds are well advised to heed the adage: for consumption and
Don’t put all your eggs in one basket. government purchases

A second advantage claimed by mutual fund The left side of this equation (Y - C - G) is the
companies is that mutual funds give ordinary total income in the economy that remains after
people access to the skills of professional paying for consumption and government
money managers. The managers of most purchases: This amount is called national
mutual funds pay close attention to the saving, or just saving, and is denoted S.
developments and prospects of the companies Substituting S for Y − C − G, we can write the
last equation as S - I.
in which they buy stock.
This equation states that saving equals
It is hard to “beat the market” by buying good investment
stocks and selling bad ones. In fact, mutual
private saving
funds called index funds, which buy all the
the income that
stocks in a given stock index, perform
households have left
somewhat better on average than mutual after paying for taxes and
funds that take advantage of active trading by consumption
professional money managers.
In particular, because households receive
The explanation for the superior performance income of Y, pay taxes of T, and spend C
of index funds is that they keep costs low by on consumption, private saving is Y - T - C.
buying and selling very rarely and by not
having to pay the salaries of professional public saving
money managers. the tax revenue that the
government has left after
paying for its spending

The government receives T in tax revenue and

spends G on goods and services. If T exceeds
G, the government runs a budget surplus
because it receives more money than it

This surplus of T - G represents public saving.

budget surplus
an excess of tax revenue
A closed economy is one that does not over government
interact with other economies. In particular, a spending
closed economy does not engage in
budget deficit
international trade in goods and services, nor
a shortfall of tax revenue
does it engage in international borrowing and from government
lending. spending
Because a closed economy does not engage in If the government spends more than it receives
international trade, imports and exports are in tax revenue, then G is larger than T. In this
exactly zero. Therefore, net exports (NX) are case, the government runs a budget deficit,
also zero. We can now simplify the identity as and public saving (T - G) is a negative number.

market for loanable funds

the market in which those
who want to save supply
funds and those who The nominal interest rate is the monetary
want to borrow to invest return to saving and the monetary cost of
demand funds borrowing. It is the interest rate as usually
loanable funds refers to all income that
people have chosen to save and lend out, The real interest rate is the nominal interest
rather than use for their own consumption, and rate corrected for inflation; it equals the
to the amount that investors have chosen to nominal interest rate minus the inflation rate.
borrow to fund new investment projects. In the
market for loanable funds, there is one interest Because inflation erodes the value of money
rate, which is both the return to saving and the over time, the real interest rate more
cost of borrowing. accurately reflects the real return to saving and
the real cost of borrowing. Therefore, the
The economy’s market for loanable funds, like supply and demand for loanable funds depend
other markets in the economy, is governed by on the real (rather than nominal) interest
supply and demand. rate, and the equilibrium

The supply of loanable funds comes from Policy 1: Saving Incentives

people who have some extra income they want
to save and lend out. saving is an important long-run determinant of a nation’s
saving is the source of the supply of
loanable funds. Principles of Economics involved:

The demand for loanable funds comes from  a country’s standard of living depends
households and firms who wish to borrow to on its ability to produce goods and
make investments services.
 people respond to incentives
investment is the source of the demand
for loanable funds. In response to this problem, some economists
and lawmakers have proposed reforming the
The adjustment of the interest rate to the tax code to encourage greater saving.
equilibrium level occurs for the usual reasons.
If the interest rate were lower than the the tax change would alter the incentive for
equilibrium level, the quantity of loanable households to save at any given interest rate,
funds supplied would be less than the quantity it would affect the quantity of loanable funds
of loanable funds demanded. supplied at each interest rate. Thus, the supply
of loanable funds would shift. The demand for
The resulting shortage of loanable funds would loanable funds would remain the same because
encourage lenders to raise the interest rate the tax change would not directly affect the
they charge. A higher interest rate would amount that borrowers want to borrow at any
encourage saving (thereby increasing the given interest rate.
quantity of loanable funds supplied) and
discourage borrowing for investment (thereby Because saving would be taxed less heavily
decreasing the quantity of loanable funds than under current law, households would
demanded). increase their saving by consuming a smaller
fraction of their income.

With a lower cost of borrowing, households and

Conversely, if the interest rate were higher firms are motivated to borrow more to
than the equilibrium level, the quantity of finance greater investment. Thus, if a
loanable funds supplied would exceed the reform of the tax laws encouraged greater
quantity of loanable funds demanded. As saving, the result would be lower interest rates
lenders compete for the scarce borrowers, and greater investment.
interest rates would be driven down. In this
way, the interest rate approaches the
equilibrium level at which the supply and
demand for loanable funds exactly balance.
Policy 2: Investment Incentives
In essence, this is what Congress does when it
institutes an investment tax credit, which it
does from time to time. An investment tax
credit gives a tax advantage to any firm
building a new factory or buying a new piece of
First, would the law affect supply or demand? labor force
Because the tax credit would reward firms that the total number of
borrow and invest in new capital, it would alter workers, including both
investment at any given interest rate and, the employed and the
thereby, change the demand for loanable unemployed
unemployment rate
Second, which way would the demand curve the percentage of the
shift? Because firms would have an incentive to labor force that is
increase investment at any interest rate, the unemployed
quantity of loanable funds demanded labor-force participation
would be higher at any given interest rate
rate. the percentage of the
adult population that is in
Third, consider how the equilibrium would the labor force
change. the increased demand for loanable
funds raises the interest rate and the higher natural rate of
interest rate in turn increases the quantity of unemployment
loanable funds supplied. the normal rate of
unemployment around
Thus, if a reform of the tax laws which the unemployment
encouraged rate fluctuates
greater investment, the result would be
cyclical unemployment
higher interest rates and greater saving.
the deviation of
unemployment from its
Policy 3: Government Budget natural rate
Deficits and Surpluses
discouraged workers
Governments finance budget deficits by individuals who would
borrowing in the bond market, and the like to work but have
accumulation of past government borrowing is given up looking for a job
called the government debt.
frictional unemployment
A budget surplus, an excess of tax revenue unemployment that
over government spending, can be used to results because it takes
time for workers to search
repay some of the government debt. If
for the jobs that best suit
government spending exactly equals tax
their tastes and skills
revenue, the government is said to have a
balanced budget structural unemployment
unemployment that
crowding out
results because the
a decrease in investment
number of jobs available
that results from
in some labor markets
government borrowing
is insufficient to provide
a job for everyone who
wants one

job search
the process by which
workers find appropriate
jobs given their tastes
and skills
unemployment insurance ECON DEV: GLOBAL
a government programs
that partially protects PERSPECTIVE
workers’ incomes when Absolute poverty A situation
they become unemployed
of being unable to meet
union the minimum levels of income,
a worker association that food, clothing, health care,
bargains with employers shelter, and other essentials.
over wages, benefits, and
working conditions Subsistence economy An
economy in which production
collective bargaining is mainly for personal consumption
the process by which
unions and firms agree on and the standard of
the terms of employment living yields little more than
basic necessities of life—food,
strike shelter, and clothing.
the organized withdrawal
of labor from a firm by a Development The process
union of improving the quality of
all human lives and capabilities
efficiency wages by raising people’s levels
above-equilibrium wages of living, self-esteem, and
paid by firms to increase freedom.
worker productivity
Developing countries
Countries of Asia, Africa, the
Middle East, Latin America,
eastern Europe, and the former
Soviet Union that are presently
characterized by low levels of
living and other development
deficits. Used in the development
literature as a synonym
for less developed countries.

Traditional economics An
approach to economics that
emphasizes utility, profit
maximization, market efficiency,
and determination of

Political economy The

attempt to merge economic
analysis with practical politics—
to view economic activity in
its political context.

Development economics
The study of how economies
are transformed from stagnation
to growth and from low income
to high-income status,
and overcome problems of
absolute poverty. incomes accruing to residents
from abroad, less the income
earned in the domestic economy accruing to persons
More developed countries
(MDCs) The now economically Gross domestic product
advanced capitalist countries (GDP) The total final output
of western Europe, of goods and services produced
North America, Australia, by the country’s economy,
New Zealand, and Japan. within the country’s territory,
by residents and nonresidents,
Less developed countries A regardless of its allocation
synonym for developing between domestic and foreign
countries. claims.

Globalization The increasing Functionings What people

integration of national do or can do with the commodities
economies into expanding of given characteristics
international markets. that they come to possess
or control.
Social system The organizational
and institutional structure of a society, including Capabilities The freedoms
its values, attitudes, power structure, and traditions. that people have, given their
personal features and their
Values Principles, standards, command over commodities.
or qualities that a society or
groups within it considers Sustenance The basic goods
worthwhile or desirable. and services, such as food,
clothing, and shelter, that are
Attitudes The states of mind necessary to sustain an average
or feelings of an individual, human being at the bare minimum
group, or society regarding level of living.
issues such as material gain,
hard work, saving for the Self-esteem The feeling of
future, and sharing wealth. worthiness that a society enjoys
when its social, political, and
Institutions Norms, rules economic systems and institutions
of conduct, and generally promote human values
accepted ways of doing such as respect, dignity, integrity,
things. Economic institutions and self-determination.
are humanly devised
constraints that shape human Freedom A situation in
interactions, including both which a society has at its
informal and formal “rules of disposal a variety of alternatives
the game” of economic life in from which to satisfy its
the widely used framework of wants and individuals enjoy
Douglass North. real choices according to their
Income per capita Total Millennium Development
gross national income of a Goals (MDGs) A set of eight goals adopted by the
country divided by its total United Nations in 2000: to eradicate extreme poverty
population. and hunger; achieve universal primary education; promote
gender equality and empower women; reduce child
Gross national income mortality; improve maternal health; combat HIV/AIDS,
(GNI) The total domestic malaria, and other diseases; ensure environmental
and foreign output claimed sustainability; and develop a global partnership for
by residents of a country. It development. The goals are assigned specific targets to be
comprises gross domestic achieved by 2015.
product (GDP) plus factor

1. Lower levels of living and productivity

2. Lower levels of human capital

3. Higher levels of inequality and absolute poverty

4. Higher population growth rates

5. Greater social fractionalization

6. Larger rural populations but rapid rural-to-urban


7. Lower levels of industrialization

8. Adverse geography

9. Underdeveloped financial and other markets

Sector A subset (part) of an
economy, with four usages in 10. Lingering colonial impacts such as poor
economic development: institutions and often external dependence.
technology (modern and
traditional sectors); activity World Bank An organization
(industry or product sectors); known as an “international
trade (export sector); and financial institution”
sphere (private and public that provides development
sectors) funds to developing countries
in the form of interest-bearing
loans, grants, and technical

Low-income countries
(LICs) In the World Bank
classification, countries with
a GNI per capita of less than
$1,025 in 2011.

Middle-income countries In
the World Bank classification,
countries with a GNI per capita
between $1,025 and $12,475
in 2011.

Newly industrializing
countries (NICs) Countries
at a relatively advanced
level of economic development
with a substantial and
dynamic industrial sector and
with close links to the international
trade, finance, and
investment system. Purchasing power parity
(PPP) Calculation of GNI
Least developed countries using a common set of international
A UN designation of countries prices for all goods
with low income, low human and services, to provide more
capital, and high economic accurate comparisons of living
vulnerability. standards.

Human capital Productive Human Development Index

investments in people, such (HDI) An index measuring
as skills, values, and health national socioeconomic development,
resulting from expenditures based on combining
on education, on-the-job measures of education, health,
training programs, and and adjusted real income per
medical care. capita.

Gross national income Diminishing marginal utility

(GNI) The total domestic The concept that the subjective
and foreign output claimed by value of additional consumption
residents of a country, consisting lessens as total consumption
of gross domestic product becomes higher.
(GDP) plus factor incomes
earned by foreign residents,
minus income earned in the
domestic economy by nonresidents.
Common characteristics of developing
Value added The portion countries
of a product’s final value that
is added at each stage of production. These features in common are on average and with
great diversity, in comparison with developed
Depreciation (of the capital
stock) The wearing out of countries:
equipment, buildings, infrastructure,
and other forms of 1. Lower levels of living and productivity
capital, reflected in write-offs 2. Lower levels of human capital
to the value of the capital
3. Higher levels of inequality and absolute
Capital stock The total  Absolute Poverty
amount of physical goods
existing at a particular time  World Poverty
that have been produced for 4. Higher population growth rates
use in the production of other
goods and services. 5. Greater social fractionalization
6. Larger rural population - rapid migration to
Gross domestic product cities
(GDP) The total final output
of goods and services produced 7. Lower levels of industrialization and
by the country’s economy manufactured exports
within the country’s territory
8. Adverse geography
by residents and nonresidents,
regardless of its allocation  Resource endowments
between domestic and foreign 9. Underdeveloped financial and other
 Imperfect markets producers and consumers
need to make efficient decisions
 Incomplete information resulting in underperforming
10. Colonial Legacies - poor institutions etc. markets.
 Institutions Property rights The
 Private property acknowledged right to use
and benefit from a tangible
 Personal taxation (e.g., land) or intangible (e.g.,
 Taxes in cash rather than in kind intellectual) entity that may
include owning, using, deriving
Absolute poverty The
income from, selling, and
situation of being unable or
only barely able to meet the
subsistence essentials of food,
clothing, shelter, and basic
health care.

Crude birth rate The number

of children born alive each
year per 1,000 population.

Dependency burden The

proportion of the total population
aged 0 to 15 and 65+,
which is considered economically
unproductive and therefore
not counted in the labor

Fractionalization Significant
ethnic, linguistic, and other
social divisions within a

Resource endowment A
nation’s supply of usable
factors of production, including
mineral deposits, raw materials,
and labor.

Infrastructure Facilities that

enable economic activity and
markets, such as transportation,
communication and
distribution networks, utilities,
water, sewer, and energy
supply systems.

Imperfect market A market

in which the theoretical How Low-Income Countries Today Differ from
assumptions of perfect competition Developed Countries in Their Earlier Stages
are violated by the
existence of, for example, a • Eight differences
small number of buyers and
sellers, barriers to entry, and  Physical and human resource
incomplete information.
Incomplete information The
absence of information that
 Per capita incomes and levels of GDP in
relation to the rest of the world

 Climate

 Population size, distribution, and


 Historic role of international migration

 International trade benefits

 Basic scientific/technological research

and development capabilities

 Efficacy of domestic institutions