Economic Growth - Theories
In this section we look at some of the theories about economic growth - what causes it and how
can we avoid problems that may arise from growth that is too fast? We also consider how it may
be linked to other economic variables. The theories considered are:
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T1 The roller-coaster of growth - why?
T2 Costs of growth - who pays?
T3 Sources of growth - where does it come from?
T4 Boosting growth - how can we grow more?
Economic Growth - Explanation
Economic growth is growth in the level of national income. There are various measures of
national income, but the one used in the Virtual Economy model is gross domestic product .
We measure growth as the percentage change in GDP. However, it is very important that we only
take the percentage change in real GDP . This means the change in GDP after inflation has
been taken into account.
Economic growth tends to follow a cyclical pattern. There may be boom periods when economic
growth is faster, but these may well be followed later by periods when the economy slows right
down. This pattern is known as the trade cycle
or business cycle.
Economic Growth Theories - The Roller-Coaster of Growth - Why?
Economic growth tends to occur in a cyclical pattern. This pattern is called the trade cycle
and
it can be clearly seen when looking at the behaviour of growth over the last 20 years or so. There
is a graph showing this in the explanation section on economic growth. So why do these cycles
happen? There are various theories as to the causes:
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Random shocks - events often occur that are relatively unpredictable, but have a
significant effect on the economy. Recent examples include the failure of banks in Japan,
and the collapse in SE Asia. Both of these have affected the UK a great deal.
Policy-induced - politicians have often been known to put in place policies to boost the
economy. It would be cynical to suggest that this often occurs around election time, but it
does. This can lead to booms which lead to the incoming government having to deflate to
slow the economy down again.
Imported cycles - if the rest of the world is growing in cycles, then this will affect on us.
Our exports may fluctuate, which means that aggregate demand
will change and
therefore growth changes.
Expectations - expectations can have a powerful effect on growth. For example if firms
expect there to be a slowdown, they may delay investment plans. If they do that then
aggregate demand
will fall. If aggregate demand falls, so does growth. A self-fulfilling
prophecy?!?
Sunspot activity - there have also been suggestions that growth cycles are linked to
cyclical sunspot activity, but it's quite possible that people suggesting this have been
themselves affected by sunspot activity (or some illegal substance!).
Economic Growth Theories - Costs of Growth - Who pays?
'Growth is good, recession is bad'. This is the standard view of economic growth, and it tends to
be treated as the Holy Grail of economic policy. However, it may not always be good. Possible
costs of growth include:
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Inequality of income - growth rarely delivers its benefits evenly. It often rewards the
strong, but gives little to the economically weak. This will widen the income distribution in
the economy.
Pollution (and other negative externalities ) - the drive for increased output tends to
put more and more pressure on the environment and the result will often be increased
pollution. This may be water or air pollution, but growth also creates significantly
increased noise pollution. Traffic growth and increased congestion are prime examples of
this.
Loss of non-renewable resources - the more we want to produce, the more resources
we need to do that. The faster we use these resources, the less time they will last.
Loss of land - increased output puts further pressure on the available land. This may
gradually erode the available countryside.
Lifestyle changes - the push for growth has in many areas put a great deal of pressure
on individuals. This may have costs in terms of family and community life.
Economic Growth Theories - Sources of Growth - Where does it
come from?
Growth is not an automatic birthright for an economy. For an economy to grow, it has to create
the right conditions for growth. Growth depends to a significant extent on the resources a country
has. The better the quantity and the quality of the resources the more potential it has to grow.
The sources of growth therefore include:
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Natural resources - if an economy has a plentiful supply of natural resources it may help
it to expand. However, natural resources on their own are not enough. There also have to
be the skilled people to exploit the opportunities.
Capital - more capital generally means more production, and more production means
more growth. To get capital, countries have to invest and so the level of investment may
be a big determinant of future growth. The quality of the capital is important as well. It's
no good investing in out of date equipment!
Rate of savings - to have more tomorrow you often have to have less today (jam
tomorrow!). This is true with savings as well. To provide funds for investment there needs
to be a good level of savings. This should in turn mean more growth in the future.
Technological progress - this is perhaps the most widely accepted (and easiest to
understand) source of economic growth. This is because technology makes it possible to
produce more from the same quantity of resources (or factors of production ). This
boosts the potential level of out put of the economy. The pace of technological change
will depend on:
1. the scientific skills of the country
2. the quality of education
3. the amount of GDP devoted to research and development
Economic Growth Theories - Boosting Growth - How can we grow
more?
Governments like economic growth. It makes the people in the country better off (generally) and if
they are better off they are hopefully happier. If they are happier they are more likely to vote for
you! Because of this, many policies will be aimed at attempting to generate a high, steady rate of
economic growth. Governments don't want to let growth get out of hand because that will cause
other problems, so they aim for steady long-term growth. Generally they fail to achieve this, so
what policies can they use?
The policies to boost growth split into two types:
1. Demand-side policies
2. Supply-side policies
Demand-side policies
To boost the level of aggregate demand
and therefore growth, the government needs to use
reflationary policies . These are policies that help to generate more demand. They include:
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Cutting tax rates to boost people's disposable income
Increasing the level of government expenditure
Cutting interest rates to encourage more borrowing and spending
Supply-side policies
These are policies that aim to boost the potential for the economy to grow - in other words to
supply more. They are policies that should make the economy more productive and more
responsive to change. Examples include:
1. Cutting tax rates - this gives people the incentive to work harder and be more productive
2. Cutting benefits - this gives the unemployed a bigger incentive to find a job; a harsh
policy (but a fair one???).
3. Promoting education and training - this should make the workforce more skilled and
therefore more productive.
4. Promoting research and development (R & D) - spending on R & D will help find new
more efficient ways to produce and should lead to better and more varied products.
5. Promoting mobility - if the economy is to be as flexible as possible, people need to
retrain where necessary and they need to move to where the jobs are. The government
has to help encourage this.
Try thinking of policies it could actually use to achieve these goals.