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AS Macroeconomics / International Economy

Economic Growth

Growing economies provide the means for people to enjoy better living standards and for more of us to find work. But what is economic growth and how best can a country achieve it?

Defining economic growth

Economic growth is best defined as a long-term expansion of the productive potential of the economy. Sustained economic growth should lead higher real living standards and rising employment.  Short term growth is measured by the annual % change in real GDP.

Growth and the Production Possibility Frontier

An increase in long run aggregate supply is illustrated by an outward shift in the PPF.

Advantages of Economic Growth

Sustained economic growth is a major objective of government policy – not least because of the benefits that flow from a growing economy.

• Higher Living Standards – for example measured by an increase in real national income per head of population – see the evidence shown in the chart below
• Employment effects: Growth stimulates higher employment. The British economy has been growing since autumn 1992 and we have seen a large fall in unemployment and a rise in the number of people employed.
• Fiscal Dividend: Growth has a positive effect on government finances - boosting tax revenues and providing the government with extra money to finance spending projects
• The Investment Accelerator Effect: Rising demand and output encourages investment in new capital machinery – this helps to sustain the growth in the economy by increasing long run aggregate supply.
• Growth and Business Confidence: Economic growth normally has a positive impact on company profits & business confidence – good news for the stock market and also for the growth of small and large businesses alike

Rising national income boosts living standards

And an expanding economy provides the impetus for a rising level of employment and a falling rate of unemployment. This has certainly been the case for the British economy over the last decade.

Disadvantages of economic growth

There are some economic costs of a fast-growing economy. The two main concerns are firstly that growth can lead to a pick up in inflation and secondly, that growth can have damaging effects on our environment, with potentially long-lasting consequences for future generations.

• Inflation risk: If the economy grows too quickly there is the danger of inflation as demand races ahead of aggregate supply. Producer then take advantage of this by raising prices for consumers
• Environmental concerns: Growth cannot be separated from its environmental impact. Fast growth of production and consumption can create negative externalities (for example, increased noise and lower air quality arising from air pollution and road congestion, increased consumption of de-merit goods, the rapid growth of household and industrial waste and the pollution that comes from increased output in the energy sector) These externalities reduce social welfare and can lead to market failure. Growth that leads to environmental damage can have a negative effect on people’s quality of life and may also impede a country’s sustainable rate of growth.  Examples include the destruction of rain forests, the over-exploitation of fish stocks and loss of natural habitat created through the construction of new roads, hotels, retail malls and industrial estates.

Many economists and environmentalists are concerned about the impact that rapid economic growth can have on our limited scarce resources and our environment.

The trend rate of economic growth

Another way of thinking about the trend growth rate is to view it as a safe speed limit for the economy. In other words, an estimate of how fast the economy can reasonably be expected to grow over a number of years without creating an increase in inflationary pressure.

• Above trend growth – positive output gap: If the economy grows too quickly (much faster than the trend) – then aggregate demand will eventually exceed long-run aggregate supply and lead to a positive output gap emerging (excess demand in the economy). This can lead to demand-pull and cost-push inflation.
• Below trend growth – negative output gap: If the economy experiences a sustained slowdown or recession (i.e. growth is well below the trend rate) then output will fall short of potential GDP leading to a negative output gap. The result is downward pressure on prices and rising unemployment because of a lack of aggregate demand.

The importance of the supply-side of the economy

The trend rate of growth is determined mainly by the supply-side capacity of a country – i.e. the extent to which LRAS increases year-on-year to meet a higher level of demand for goods and services. Potential output in the long run depends on the following factors

• The trend growth of the working population i.e. the size of the active labour supply (e.g. those people able available and willing to find paid employment)
• The growth of the nation’s stock of capital – driven by the level of capital investment in new buildings, machinery, plant and technology
• The trend rate of growth of factor productivity (including labour productivity) – a measure of gains in factor efficiency
• Technological improvements driven by innovation and invention which reduce the costs of supplying goods and services and which lead to an outward shift in a country’s production possibility frontier

Long Run Aggregate Supply and the Trend Rate of Growth

The effects of an increase in long run aggregate supply are traced in the diagram below. An increase in LRAS allows the economy to operate at a higher level of aggregate demand – leading to sustained increases in real national output.

Potential output in the long run depends on the following factors

(1) The growth of the labour force e.g. those people able available and willing to find employment

If the government can increase the number of people willing and able to actively seek paid employment, then the employment rate increases leading to a higher output of goods and services. The Government has invested heavily in a number of employment schemes designed to raise employment including New Deal and reforms to the tax and benefit system. Changes in the age structure of the population also affect the total number of people seeking work. And we might also consider the effects that migration of workers into the UK from overseas, including the newly enlarged European Union, can have on our total labour supply

(2) The growth of the nation’s stock of capital – driven by the level of fixed capital investment.

A rise in capital investment adds directly to GDP in the sense that capital goods have to be designed, produced, marketed and delivered. Higher investment also provides workers with more capital to work with. New capital also tends to embody technological improvements which providing workers have sufficient skills and training to make full and efficient use of their new capital inputs, should lead to a higher level of productivity after a time lag.

(3) The trend rate of growth of productivity of labour and capital. For most countries it is the growth of productivity that drives the long-term growth. The root causes of improved efficiency come from making markets more competitive and achieving better productivity within individual plants and factories.  Increased investment in the human capital of the workforce is widely seen as essential if the UK is to improve its long run productivity performance – for example – increased spending on work-related training and improvement in the UK education system at all levels.

(4) Technological improvements are important because they reduce the real costs of supplying goods and services which leads to an outward shift in a country’s production possibility frontier

The current growth phase for the UK is the longest period of continuous growth for over forty years.