Economic Growth

Key Terms
Economic Growth: An increase in the productive capacity of the economy.

Sustainable Growth: Economic growth which does not impose costs on future generations.

Trend Growth: The long run average growth rate that the economy can sustain without generating inflationary pressure.

Actual Growth: An increase in the productive capacity of the economy matched by an increase in demand.

Potential Growth: An increase in the productive capacity of the economy, not necessarily matched by demand.
Theory

Types of Economic Growth



Short-run (current or actual) economic growth

SR economic growth occurs as a result of increase in aggregate demand. An increase in AD brings spare capacity into use as the derived demand for factors of production increases. The output gap closes and the economy moves closer to its productive potential (moves closer to the PPF).

Such growth is not sustainable and will be brought to an end when the economy employs all it's resources (space capacity). At this point any increase in AD would be purely inflationary.


Long-run economic growth (Trend rate of growth)

Long run economic growth requires an increase in the productive capacity of the economy.

Causes of LR economic growth:

  • Increased capital

  • Increase in working population e.g. through:

  • Immigration
  • Higher birth rate
  • Tax incentives e.g. lower income tax
  • Stricter benefits system

  • Increase in labour productivity e.g. through better education

  • Discovering new raw materials

  • Technological improvements (improve the productivity of capital of labour)

  • Entrepreneurial culture
    • Advantages of Economic Growth
    1) Better living standards as GDP increases

    Economic growth due to increased productivity = lower costs. Lower costs for firms may result in higher wages and increased spending. Rising income therefore suggests better living standards.


    2) Reduced unemployment

    Economic growth due to increased productivity lowers costs or production and allows firms to take on more workers. However this may not always be the case as firms may substitue labour with more advanced capital.

    As well as achieving a macro-economic objective, reduced unemployment also results in reduced social costs e.g:

  • Crime
  • Suicide
  • Divorce


    • 3) Government Revenue

    Economic growth will have an immediately positive effect on government finances. As employment rises the demand for unemployment benefits will fall and as incomes rise so will tax revenue


    4) Increased Business Confidence / Accelerator Effect

    Economic growth indicates to foreign and domestic investors that the time is right to invest. This is known as a positive accelerator effect.
    Disadvantages of Economic Growth
    1) Inequality

    The benefits of economic growth may not be evenly distributed. A rise in GDP may be concentrated in the hands of the wealthy, the number of people in poverty remains the same.


    2) Negative externalities

    Economic growth creates negative externalities. Such as increased pollution from investment in infrastructure (roads) or use of new technologies.


    3) Over exploitation of scarce finite resources

    Rapid economic growth may lead to an over exploitation of scarce finite economic resources, this may limit growth in the future. However as firms invests more in technology they become better at extracting resources.
    Foreign Economic Growth

    Economic growth in foreign country and the impact for the U.K.


    Here will will discuss the implication for the U.K from economic growth in another country.


    Advantages of Foreign Economic Growth for the U.K.

    1) Foreign Direct Investment (FDI)

    When foreign countries experience economic growth, the population will become wealthier. Foreign businesses are likely therefore to invest in the U.K. economy. By setting up offices and factories in the U.K this will lead to a number of benefits for the U.K economy.

  • Economic growth
  • Increase in employment
  • Increase in living standards
  • Improvement in government finances

    • 2) Improvement in the balance of payments

    As we have established, foreign economic growth results in a wealthier foreign population. Consumers in foreign countries will therefore have more income to spend on U.K good. This increases exports and results in an improvement in the balance of payments on the current account.


    3) Imports and supply-side benefits

    Foreign economic growth may be as a result of better quality resources. The U.K could import better quality resources from the foreign country thus achieving higher domestic productivity.



    Disadvantages of Foreign Economic Growth for the U.K.

    1) Foreign Comparative Advantage

    If foreign economic growth is a result of an increase in comparative advantage this may make U.K. goods relatively uncompetitive. This may result in a net fall in exports from the U.K. as countries import from the foreign country.

    In an extreme scenario, a long-term foreign comparative advantage may compete U.K. industries out of existance perhaps resulting in structural unemployment in the U.K.


    2) Dual inflation

    Economic growth in a foreign country can lead to both demand-pull and cost-push inflation. Foreign economic growth will result in an increase in the price level in the foreign country. This will increase the price of imports thus increasing production costs for U.K. firms shifting the AS curve to the left and causing cost-push inflation.

    Foreign economic growth will also lead to an increase in U.K exports as foreign consumers will be richer and also an increase in FDI. This will cause the AD curve to shift right causing demand-pull inflation.


    3) "Stability is destabilising"

    Prolonged periods of economic growth and stability can lead to increased speculation. If the economy is stable then, households and firms will accumulate debts and make riskier investments in th belief that the economy will continue to be propserous.

    In the long-run the speculative bubble will burst as households recognise that the nominal value of their investments are far higher than their real value. The economist Hyman Minksy pioneered this idea that "Stability is destablising" in the financial instability hypothesis.








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