I n t h I s c h a p t e r y o u w I l L

Economist,
June 29, 1996, pp. 19–21.

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◆
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.
S u m m a r y
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
K e y C o n c e p t s
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.
Q u e s t i o n s f o r R e v i e w
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
P r o b l e m s a n d A p p l i c a t i o n s

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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?

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I N T H I S C H A P T E R
Y O U W I L L . . .
C o n s i d e r h o w
g o v e r n m e n t b u d g e t
d e f i c i t s a f f e c t t h e
U . S . e c o n o m y
D e v e l o p a m o d e l o f
t h e s u p p l y a n d
d e m a n d f o r l o a n a b l e
f u n d s i n f i n a n c i a l
m a r k e t s
L e a r n a b o u t s o m e o f
t h e i m p o r t a n t
f i n a n c i a l
i n s t i t u t i o n s i n t h e
U . S . e c o n o m y
C o n s i d e r h o w t h e
f i n a n c i a l s y s t e m i s
r e l a t e d t o k e y
m a c r o e c o n o m i c
v a r i a b l e s
U s e t h e l o a n a b l e -
f u n d s m o d e l t o
a n a l y z e v a r i o u s
g o v e r n m e n t p o l i c i e s
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.
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
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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