Growth

From WikiTextbook

Economic growth is the percentage increase in real national output in a given time period or a sustained increase in the productive potential of an economy. Countries grow at different rates. Partly this is the simple fact that they are at different stages of their economic cycle. For example, in 1999 the US economy was racing ahead but the Japanese economy seemed stuck in the mire of a prolonged slump.

But there are also supply-side explanations for differences in long-run average growth rates. This is why many economists now give increased attention to improving productivity and efficiency as a means to enhancing the growth potential of the UK economy.

Contents 1 Measuring the Size of an Economy 2 Benefits of Economic Growth 3 Costs of Economic Growth 4 Trend Growth 5 Differing Growth in Different Sectors 6 Longrun Growth and Economic Resources 7 Government Policies and Economic Growth 8 Demand and Supply side shocks 9 Problems of measuring economic growth 10 Measures of wealth 11 Measures of living standards 12 Measures of distribution of income 13 Other methods of measuring growth/wealth etc. 14 Theories of Economic Growth 15 Statistics 16 Videos 17 Links 18 Selected further reading 19 Other revision material 20 Latest news 21 Contributors

Measuring the Size of an Economy

• Gross Domestic Product (GDP) = C + G + I + F. It is the most commonly used statistic and it is measured at market prices; it includes indirect taxes and imports and exports. It is calculated by multiplying the quantity of all goods and services by its price. When this is done for all three categories, Consumer spending, Government Spending and Investments, the results are added up to find out the GDP. This is different from the GNP because all the materials used to deliver a good or service are counted as part of it, rather than just the final value.

• Gross National Product (GNP) = C + G + I + X. This means that it is the GDP plus the income earned abroad and other assets, minus the income paid out to foreign companies on their investments. This is different from the GDP because the GDP measures only the goods and services IN a nation in one year, whilst GNP only evaluates the final product. So for GDP, the construction materials used to build a house would be counted as part of it, whilst in GNP, only the final value of the house would count.

Benefits of Economic Growth

The British economy has enjoyed continuous growth of real national output since the late autumn of 1992. Eight years of growth inevitably brings a range of economic and social benefits - but there are also dangers and risks when an economy rides a fast growth path. There are many advantages of Economic growth, and these are outlined below:

Employment

Real economic growth stimulates higher employment since labour is a derived demand. An increase in real GDP should cause an outward shift in the aggregate demand for labour. Not all industries will share in the growth of an economy.

Fiscal dividends from economic growth

Growth has a positive effect on Government finances - boosting tax revenues and helping to reduce the budget deficit. More people in work, rising spending and higher company profits all contribute to an increased flow of revenue to the Treasury.

Growth and Investment

Rising demand and output encourages further investment in new capital machinery via the accelerator mechanism. This is known as income induced investment.

Business Confidence

Sustained economic growth should have a positive impact on company profits & business confidence

Living Standards

Growth improves living standards as measured by real GDP per capita although real GDP on its own is an inadequate measure of the true standard of living and quality of life.

Costs of Economic Growth

Inflation risk

Externalities

Inequality

Trend Growth

Differing Growth in Different Sectors

Longrun Growth and Economic Resources

Government Policies and Economic Growth

Demand and Supply side shocks

Demand side shocks

Supply side shocks

Potentials Demand and Supply side shocks for 2007

America declares war on some other middle-eastern oil pot

Disease Outbreak

Problems of measuring economic growth

GDP is widely used by economists to measure economic growth however is has many limitation:

• GDP does not include the black market and so in some countries where the informal sector is large a lot of transactions go unregistered and GDP is abnormally low.

• GDP does not take into account unpaid labour such as child-rearing or housekeeping. 50 years ago the amount of housework done and the time it took was much greater than it is today but GDP does not take this into account.

• It ignores volunteer, unpaid work.

• Comparing calculations can be difficult and cross-border comparisons should especally regard whether it has been calculated using purchasing power parity or current exchange rates.

• GDP counts work that produces no net charge or that results from repairing harm. An example of this is re-building after a natural disaster where spending on this would boost GDP but the economy would have been better off that the disaster not taken place. The same can be applied to spending on healthcare because spending increases and boosts GDP if more people are unwell.

• It fails to give an indication of human happiness apart from that involving physical goods and services.

• GDP does not take into account negative externalities from pollution consequent to economic growth.

• GDP per capita does not take into account positive externalities that may result from services such as education and health.

• GDP per capita excludes the value of all the activities that take place outside of the market place e.g. cost-free leisure activities like hiking.

• As the single most important figure in statistics it is subject to fraud, such as the usage of hedonic price indexing on official GDP numbers in the US, thereby creating investments out of nothing while statistically dampening inflation.

• Cross border trade within companies distorts the GDP and is done frequently to escape high taxation.

• People may buy cheap, low-durability goods over and over again, or they may buy high-durability goods less often. It is possible that the monetary value of the items sold in the first case is higher than that in the second case, in which case a higher GDP is simply the result of greater inefficiency and waste.

• Some accumulated savings and debt may not be taken into account, for example if a nation does not spend, but saves and invests overseas, its GDP will be diminished in comparison to one that spends borrowed money.

• GDP does not measure the sustainability of growth. A country may achieve a temporarily high GDP by over-exploiting natural resources or by misallocating investment. Oil-rich states can sustain high GDPs without industrializing, but this high level would no longer be sustainable if the oil runs out.

• GDP does not account for the long term costs of economic growth sustained by environmental degradation.

• As a measure of actual sale prices, GDP does not capture the economic surplus between the price paid and subjective value received, and can therefore underestimate aggregate utility.

• The annual growth of real GDP is adjusted by using the "GDP deflator", which tends to underestimate the objective differences in the quality of manufactured output over time. Therefore the GDP figure may underestimate the degree to which improving technology and quality-level are increasing the real standard of living.

• GDP does not take disparity in incomes between the rich and poor into account.

The limits of GDP (or GNP, a slightly different notion) can be summed up in the words of two critics. Robert Kennedy said:

The gross national product includes air pollution and advertising for cigarettes and ambulances to clear our highways of carnage. It counts special locks for our doors and jails for the people who break them. GNP includes the destruction of the redwoods and the death of Lake Superior. It grows with the production of napalm, and missiles and nuclear warheads... it does not allow for the health of our families, the quality of their education, or the joy of their play. It is indifferent to the decency of our factories and the safety of our streets alike. It does not include the beauty of our poetry or the strength of our marriages, or the intelligence of our public debate or the integrity of our public officials. It measures everything, in short, except that which makes life worthwhile.

The second critic, Simon Kuznets the inventor of the GDP, in his very first report to the US Congress in 1934 said:

...the welfare of a nation can scarcely be inferred from a measure of national income. If the GDP is up, why is America down? Distinctions must be kept in mind between quantity and quality of growth, between costs and returns, and between the short and long run. Goals for more growth should specify more growth of what and for what.

Measures of wealth

Wealth can be measured using numerous methods, since there are many determinants of wealth. Measuring wealth is simply trying to denote how many assets people own, in comparison with others. For example, the number of dwellings per head of population provides an insight into how much property is owned by each person on average, informing us of an element of an average person’s wealth. Quality of the housing stock is an obvious method of portraying wealth since a house which has running water, gas, electricity and can remove sewerage is clearly owned by a wealthier man than somewhere that lacks these facilities and has no permanent roof. The number of televisions per head is another simple idea of trying to determine the average wealth of a population. A nation with an average number of 0.8 televisions per head must be wealthier than a nation with 0.2, since televisions are a luxury good, hence as income increases, demand for these products increases, suggesting that incomes are higher in regions where the number of televisions per head is higher. This could be said for any luxury good, for example another measure could be the number of computers per head. Another way of measuring wealth could be the average spent on a weekly food shop, since wealthier families will be prepared to spend more.

Measures of living standards

As with measures of wealth, there are multiple measures of living standards. The most obvious measures would be measures of health, for example, infant mortality rates, life expectancy and doctors and dentists per head since a healthier country will generally have a higher standard of living. In addition to these types of measures, there would be others, such as educational measures, for example the literacy rate and percentage of students who continue to 6th form and university. These analyse how well a country is educating its population and how large the skill banks of the future will be. Measures that take into account how much people work also help in evaluating living standards; a nation that has a high average income, good health standards but whose average working hours per week are low in comparison with others is clearly a country with high standards of living. Finally, arbitrary measures such as political freedom and unemployment rates are good indicators of the living standards of a country, since a country within which you are politically free and in a tiny minority if unemployed will be a country of good standards of living.

Measures of distribution of income

Other indicators of changes of living standards look at the distribution of income. The Lorenz curve (right), created by Max Lorenz, an American economist, shows the percentage, ?%, of the total income that the bottom ?% account for, i.e. the bottom 20% of all households account for only 10% of the total income. The line of perfect equality represents what the graph would resemble if every person had an identical proportion of total income. This is a good measure of living standards because the further that the Lorenz curve shifts from the line of perfect equality, the more uneven the distribution of income will be. It must be remembered that a country could have a high average income due to the richest proportion of the population being exceedingly rich and raising the average, hence this measure is useful to see how the wealth is spread. The Gini coefficient is a further measure of inequality of distribution. It is a fraction with the numerator denoted by the area between the Lorenz curve and the perfect equality line and the denominator denoted by the total area under the uniform perfect distribution line.

Other methods of measuring growth/wealth etc.

As alternatives to GDP, many of measures of growth and wealth have be put forward.

Theories of Economic Growth

Adam Smith

'Invisible hand' Term used by Adam Smith to describe the natural force that guides free market capitalism through competition for scarce resources.

According to Adam Smith, in a free market each participant will try to maximize self-interest, and the interaction of market participants, leading to the exchange of goods and services. This enables each participant to be better of than when simply producing for themselves. He further said that in a free market, no regulation of any type would be needed to ensure that they mutually beneficial exchange of goods and services takes place. This is because the "invisible hand" would guide market participants to trade in the most mutually beneficial way possible, for each to gain the most possible for the exchange.

The modern conception of economic growth began with the critique of Mercantilism, especially by the physiocrats and with the Scottish Enlightenment thinkers such as David Hume and Adam Smith, and the foundation of the discipline of modern political economy. The theory of the physiocrats was that productive capacity, itself, allowed for growth, and the improving and increasing capital to allow that capacity was "the wealth of nations". Whereas they stressed the importance of agriculture and saw urban industry as "sterile", Smith extended the notion that manufacturing was central to the entire economy.

Contrary to popular belief, however, Smith was not an apologist for the capitalist class. One of his least repeated statements warned that a group of capitalists rarely gather together under one roof without the talk turning towards collusion against the public. For this reason Smith firmly favored anti-monopoly laws. Furthermore, his support of competition remained contingent on the fact that it encouraged economic growth

Adam Smith's theory of economic growth had two parts:

1) Increasing division of labor increases the productivity of labor. We have discussed Smith's ideas on the division of labor in an earlier chapter. In several example, Smith described how workers in a modern economy do jobs that are different and that enhance the productivity of one another. Thus, a group of people working in this way (whether they are aware of it or not) produce much more per person than they would be able to produce if they worked independently. Smith saw this as the main reason for rising productivity and for high standards of living, or, in his words, "that universal opulence which extends itself to the lowest ranks of the people." 2) " That the Division of Labour is limited by the Extent of the Market" This was the title of Smith's Chapter 3 and a key point in his theory of economic growth. He writes "the extent of this division [of labor] must always be limited by the extent of that power, or, in other words, by the extent of the market. When the market is very small, no person can have any encouragement to dedicate himself entirely to one employment, ...." Taking the example of nail-making, he goes on, " Such a workman at the rate of a thousand nails a day, and three hundred working days in the year, will make three hundred thousand nails in the year. But in [a small market in an isolated community] it would be impossible to dispose of one thousand, that is, of one day's work in the year." Thus large markets are essential to division of labor, and to high productivity, and growing markets are essential to increasing division of labor and growing productivity.

David Ricardo

Ricardo was an 18th century economist, and is considered one of the greatest ever. His most famous book, Principles of Political Economy and Taxation, raised many economic theories that are still used today. This includes to theory of wages. Ricardo basically created the minimum wage.

This book introduces the theory of comparative advantage. According to Ricardo's theory, even if a country could produce everything more efficiently than another country, it would reap gains from specialising in what it was best at producing and trading with other nations. (Case & Fair, 1999: 812–818). Ricardo believed that wages should be left to free competition, so there should be no restrictions on the importation of agricultural products from abroad. To summarise:

• Formalised notion of diminishing returns, but did not take innovation into account

• Showed some of the welfare gains from specialisation and international trade based on comparative advantage

Robert Solow

Robert Solow (born August 23, 1924) is an American economist particularly known for his work on the theory of economic growth. He was awarded the John Bates Clark Medal (in 1961) and the 1987 Nobel Prize in Economics.

Developed the Neo-Classical Growth Model, which is asserts that a sustained increase in capital investment increases the growth rate only temporarily. This conclusion is reached due the fact that although the ratio of capital to labour goes up, the marginal product for additional units of capital is assumed to decline, there will be diminishing returns to capital. Eventually, the rate of return may be so low that no further net capital accumulation takes place. In which case the rate of technological progress determined the rate of growth of output. Technological progress is assumed to be exogenous i.e. lies outside the growth model.

Schumpeter

The theories of Joseph Schumpeter suggest that in order to attain economic growth and development, innovation is essential, in addition to entrepreneurship. The constant birth of new products and markets leads to increased profits and "gales of creative destruction". Creative destruction is the idea that the less efficient companies that do not innovate to find the best products and cheapest costs will be "destructed," whilst the new competitors that have devoted funding to innovation become favoured by consumers due to their lower costs and more desirable products.

Innovation is key to ensure that technology remains up to date and allows producers to maximise productivity and allow resources to be used elsewhere for other resources, improving allocative efficiency.

Schumpeter believes, as stated in his theroies, that entrepenuers and large companies are essential in order to amass the funding needed to support the necessary innovation, to prompt economic growth.

A lack of innovation leads to a stationary state, known as Walrasian equilibrium, which he claims is insufficient if aiming for economic growth. i.e. entrepreneurs disturb this equilibrium and lead to economic growth and development

Innovations are the economic applications of inventions and discoveries which trigger changes to the entire economy. Schumpeter also said phenomena such as the amount of credit in the financial system, or the rate of interest, can also affect movement in the cycle, with innovation being the most important causal factor.

Paul Romer and Paul Ormerod

Paul Romer and Paul Ormerod are associated with the new economic growth theory. This theory aims to replace the neo-classical growth model, which is that growth comes from factors which are not explained by the model. Eg. A change in consumer tastes or preferences is not explained by a supply and demand model. This is an exogenous change, ie. Change that comes from outside of the model.

New economic growth theory tries to incorporate technological progress into the model. It states that:

• Firms have an incentive to invent in order to exploit an advantage over their competitors, thereby impriving their own productivity.

• This means creativity and ideas underpin the model

• New Economic Growth theory says that growth comes from creativity and so we should foster ideas however we can. This may be through education, subsidisation of research and offer protection to intellectual property.

Statistics

Videos

Links

Selected further reading

Other revision material

Latest news

Contributors

--Dunk 04:46, 30 Jan 2007 (CST)