Written by: Edmund Quek

CHAPTER 16 ECONOMIC GROWTH

LECTURE OUTLINE 1 2 3 4 DEFINITION OF ECONOMIC GROWTH DISTINCTION BETWEEN ACTUAL GROWTH AND POTENTIAL GROWTH SOURCES OF ECONOMIC GROWTH BENEFITS AND COSTS OF ECONOMIC GROWTH

References John Sloman, Economics William A. McEachern, Economics Richard G. Lipsey and K. Alec Chrystal, Positive Economics G. F. Stanlake and Susan Grant, Introductory Economics Michael Parkin, Economics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics

2011 Economics Cafe All rights reserved.

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Written by: Edmund Quek

DEFINITION OF ECONOMIC GROWTH

Economic growth is an increase in real national income or real national output.

DISTINCTION BETWEEN ACTUAL GROWTH AND POTENTIAL GROWTH

There are two types of economic growth: actual growth and potential growth. Actual growth is an increase in actual output. Potential growth is an increase in potential output or the full-employment national output.

In the above diagram, actual growth is shown by a movement from a point inside the PPC to a point nearer to the PPC, such as from point A to point B, and potential growth is shown by an outward shift in the PPC, such as from PPC0 to PPC1. Actual growth is constrained by potential growth.

Note: Growth theorists define economic growth as an increase in real national income per capita or real national output per capital.

2011 Economics Cafe All rights reserved.

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Written by: Edmund Quek

SOURCES OF ECONOMIC GROWTH

An increase in aggregate demand will lead to actual growth.

In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 leads to an increase in actual output (Y) from Y0 to Y1. Potential output (Yf) remains at Yf0. Aggregate demand could increase due to an increase in any of its components. Consumption expenditure is determined by consumer confidence, the wealth of households, interest rates, expectations of price changes, the availability of credit and the distribution of income. For instance, when households are more optimistic about the economic outlook, they will expect their income to rise and hence increase consumption expenditure. Investment expenditure is determined by interest rates, business sentiment, business costs, capital costs, corporate income tax, technological advancements and the availability of credit. For instance, a fall in interest rates will lead to more profitable planned investments resulting in an increase in investment expenditure. When the economy is in a recession, the government may increase expenditure on goods and services to steer the economy back onto the path of expansion. Net exports are determined by the exchange rate, the domestic general price level relative to the foreign general price level, national income and foreign income. For instance an increase in foreign income will lead to an increase in net exports. For more determinants of the components of aggregate demand, refer to the notes on THE THEORY OF INCOME AND EMPLOYMENT DETERMINATION, section 4.2.

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Written by: Edmund Quek

An increase in aggregate supply independent of the cost of production will lead to potential growth and to a lesser extent, actual growth.

In the above diagram, an increase in aggregate supply (AS) from AS0 to AS1 leads to an increase in potential output (Yf) from Yf0 to Yf1 and a smaller increase in actual output (Y) from Y0 to Y1. Aggregate supply could increase due to an increase in the size of the labour force, the productivity of the labour force, the size of the capital stock or the productivity of the capital stock. The size and the productivity of the capital stock The size of the capital stock is determined by net investment which depends on corporate income tax, capital gains tax, government expenditure on capital goods, etc. Research and development, free trade, deregulation and privatisation will lead to technological advancement and hence increase the productivity of the capital stock. The size and the productivity of the labour force The size of the labour force is determined by factors such as culture (e.g. tolerance of women working), personal income tax, the governments foreign worker policy and immigration policy, etc. Human capital is the skills and knowledge that workers acquire through education and training. Education and training will increase human capital and hence the productivity of the labour force.

2011 Economics Cafe All rights reserved.

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Written by: Edmund Quek

BENEFITS AND COSTS OF ECONOMIC GROWTH

Benefits of economic growth Rise in the standard of living High economic growth will lead to a rapid rise in the standard of living. Although there is no standard measure of the standard of living, it is commonly believed that the welfare of the people depends to a large extent on the amount of goods and services available for consumption and this is directly, though not perfectly, related to national output. Full employment High economic growth will help the economy achieve full employment. The labour force is usually expanding. An increase in national output will lead to an increase in jobs. Therefore, high economic growth will ensure that sufficient new jobs are created for the new entrants in the labour force which will help the economy achieve full employment. Redistributive benefit High economic growth will put the government in a good position to redistribute income from high income groups to low income groups. When national income rises, the government can redistribute income from high income groups to low income groups to reduce income inequity without lowering anyones disposable income. Conversely, in the absence of economic growth, someones disposable income will be lowered if income is redistributed. Environmental benefit When peoples income rises, they will become more concerned with a clean environment. This is because litter, pollution and ugliness will become a matter of social concern only when economic growth has ensured the provision of basic necessities such as food, clothing and housing to the majority of the population. Costs of economic growth Lower standard of living in the short run There may be a short-run trade-off between economic growth and the standard of living. Economic growth could increase due to the diversion of resources from the production of consumer goods, such as cookies and ice-cream, to the production of capital goods, such as factories and machinery. If this happens, the amount of goods and services available for consumption and hence the standard of living may decrease in the short run. Generation of demands Economic growth may generate demands which may make people feel less contented. An increase in national output will lead to an increase in the amount of goods and services available for consumption. However, when people have more to consume, they may want to attain a higher level of consumption. Therefore, if economic growth makes people more materialistic, it may make them feel less contented.

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Written by: Edmund Quek

Environmental costs Economic growth may lead to environmental degradation. An increase in national output may lead to an increase in pollution and carbon emissions resulting in adverse effects such as acid rain and the depletion of the ozone layer. Depletion of non-renewable resources Economic growth will deplete non-renewable resources, such as fossil fuel, which may lead to shortages for future generations, unless alternatives can be found. Worsening income inequity Economic growth may worsen income inequity. The government may decrease corporate income tax to attract foreign direct investments to increase economic growth. If this happens, given that corporate income tax is progressive, income inequity will worsen. High structural unemployment High economic growth may lead to high structural unemployment. High economic growth could be due to rapid technological advancement. However, rapid technological advancement will cause skills and knowledge to become obsolete at a fast pace which will lead to high structural unemployment. Balance of payments deficit High economic growth will lead to high import growth which may lead to a persistent balance of payments deficit resulting in adverse consequences such as high imported inflation, high cost-push inflation, falling national income, rising unemployment or rising foreign debt, depending on the exchange rate system. High demand-pull inflation High economic growth may lead to high demand-pull inflation. High economic growth is usually due to a rapid increase in aggregate demand. However, when aggregate demand rises rapidly, demand-pull inflation will be high if aggregate supply does not also rise rapidly, and this is especially true when the economy is near the full-employment equilibrium.

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