Economic growth

Actual growth can be defined as an increase in real GDP and potential growth as an increase in capacity in an economy. Measures of real GDP tend to fluctuate over the course of an economic cycle. During a boom, real GDP rises fast. In a recession, it falls for at least two consecutive quarters. During a slowdown, the level of GDP may be rising, but rising below the trend.

The difference between actual output and either the trend or potential output is known as the output gap. The second of these two ways of defining the output gap is shown in the diagram.

[diagram on page 38]

If the economy is growing faster than the trend, pressures will grow in the economy, such as tight labour markets, wage pressures and shortages of raw materia;s. This is referred to as a positive output gap. It may be a sign that the economy is overheating and the inflationary pressures might persuade the Bank of England’s Monetary Policy Committee to raise interest rates.However, if the economy is growing below the trend, there is likely to be spare capacity in the economy. This situation is known as a negative output gap. It means there is scope for a cut in interest rates, which is less likely to cause inflationary pressures.

Causes of actual economic growth
Economic growth can occur because there is an increase in one of the components of AD. Here are some examples. Increased consumption might occur becuase of increased consumer confidence or the availability of credit. Increased investment increases the level of growth, and is itself dependant on the level of growth (i.e. it has an accelerating effect on growth rates). Government spending on education or health might cause growth. Export-led growth has the added advantage of improving the current account of the balacne of payments.

Growth can also occur because of an increase in aggregate supply. This might happen because production costs fall – for example, labour markets might become more competitive thanks to immigration or an increase in the birth rate – or because of government supply side policy such as deregulation the markets (removing constraints that limit competition).

A shift of the AD or AS curve to the right should cause an increase in actual growth. However, if AD increases and the AD curve is crossing the the vertical part of the AD curve, the only effect will be higher prices, not increased GDP. Similarly, if AS increases and the AD curve is crossing the AS curve on its horizontal part, there will be no change in the equilibrium and there will be no change in price levels or output.

Causes of potential economic growth
Potential economic growth can only occur when the vertical part of the AS curve shifts to the right, increasing the amount that the economy could produce. Using another model, potential economic growth increases when the PPF shifts to the right.

Constraints on growth
There are several factors constraining growth:

  • Absence of capital markets. One of the main reasons why Latin America grows more slowly than the Asian subcontinent is that Asia has more credible and efficient capital markets. In many economies in sub-Saharan Africa, the interest charged on credit, if credit is available at all, is typically over 50%. One of the issues is the asymmetric information in credit markets, where the lender knows very little about the borrower and charges high rates to cover the enormous risk. The only people able to afford these high rates are likely to be among the more corrupt borrowers, which makes it even less likely that people will lend. The market then becomes a missing market, in the sense that there is no equilibrium price of credit where buyers and sellers can agree on a rate of interest.
  • Government instability. When governments are incompetent or lack transparency or strong political backing, the economy cannot attract investment and the currency might become unstable. The government might have a fiscal deficit which means that it has very little power to encourage growth.
  • Labour market problems. A shortage of skilled labour is  a major contraint on growth. As countries get richer, birth rates tend to fall dramatically in the long run this means that the labour supply will fall.  One of the most effective policies  for reducing this in high income economies is to allow increased immigration, although in low-income economies the exit of skilled workers (known as brain-drain) exacerbates the skill problems.
  • External constraints. Trade is a key driver of growth. Uneven access to world markets owing to tariffs and subsidies can prevent an economy from growing. Global recession or fears or terrorism also low down trade, as does volatility in exchange rate markets. Figures suggest that for every 3% growth in world trade there is a 1% increase in world GDP, and therefore anything that hold back international trade is likely to act as a constraint on growth.

Benefits of growth

Growth benefits employees, firms and governments in the following ways:

  • Employees. Incomes and wealth rise when there is economic growth. Standards of living rise as long as the costs of living do not increase at the same rate. In other words, real growth means that real incomes rise. Increases in growth can mean that wealth in the form of assets sch as shares and houses increases.
  • Firms. Firms tend to make more profit when there is economic growth. In times of growth, consumer spending usually rises, which means that firms sell more. As revenues and profits increase, firms can take on more workers and are more likely to invest. This increases future growth prospects.
  • Governments. When incomes and assets rise in price, people pay more income and capital gains tax. Governments also have fewer demands to pay unemployment benefits. So in times of economic growth the government is more likely to enjoy a healthier fiscal position.

Costs of growth

Despite the benefits listed above, growth incurs the following costs:

  • Income inequality. The unwaged and unskilled are less likely to benefit from increased incomes. While money might eventually ‘trickle-down’  to lower-income groups, there might equally be a two-speed economy where the incomes of some people accelerate, but the rest cannot get out of the low-skill ‘lane’. The type of production tends to change during periods of economic growth, so there is likely to be short-term unemployment for people who do not have labour market flexibility.
  • Environmental problems. Depletion of natural resources and external costs such as carbon emissions an other forms of pollution are likely to increase with economic growth. However, high-income governments can use their increased ta tax revenue to clean up the environment.
  • Balance of payments problems on the current account. With higher incomes, domestic consumers suck in more imports and there is less incentive for forms to export. However, if growth were export-led, the current account would improve.
  • Bottlenecks in the economy. When there is little spare capacity in the economy, factos of production such as skilled labour and fuel rise in price. Monopoly power might also develop, which can be used a a barrier to the entry of new firms. This can be shown by an increasingly elastic AS curve.
  • Social dislocation and stress. Higher incomes have to be earned. With increased pay there are usually increased responsibilities. There may be more travel and the need to move further afield as firms grow. However, with higher incomes people can often afford to work fewer hours, go on more luxurious holidays, pay for their children’s education, or retire early. So social life may or may not improve as the economy grows.
  • Problems of rapid growth. Rapid growth can cause short-term spikes in prices. If a country grows too quickly there might be bad planning, corner cutting and shoddy workmanship. However, rapid growth might just need time to settle down in terms of income distribution, and a strong government such as that in CHina can ensure that growth is planned efficiently.
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