Economic Growth

Benefits of Economic Growth  

Economic Growth means an increase in real GDP. This increase in real GDP means there is an increase in the value of national output / national expenditure.

The Benefits of economic growth include:

1. Higher Incomes. This enables consumers to enjoy more goods and services

2. Lower unemployment With higher output firms tend to employ more workers creating more employment.

3. Lower Government borrowing. Economic growth creates higher tax revenues and there is less need to spend money on benefits such as unemployment benefit. Therefore economic growth helps to reduce borrowing. Economic growth also plays a role in reducing debt to GDP ratios

4. Improved public services. With increased tax revenues the government can spend more on the NHS and education e.t.c.

5. Money can be spent on protecting the environmen

Causes of Economic Growth

Economic growth means an increase in Real GDP. Economic growth means there is an increase in national output and national income.

Economic growth is caused by two main factors:

an increase in aggregate demand

an increase in aggregate supply (productive capacity)

Economic Growth in UK

See latest stats on economic growth

Demand Side Causes

In the short term, economic growth is caused by an increase in aggregate demand (AD). If there is spare capacity in the economy then an increase in AD will cause a higher level of real GDP.

AD= C + I + G + X- M

C= Consumer spending

I = Investment

G = Government spending

X = Exports

M = Imports

Graph Showing Increase in AD

AD can increase for the following reasons:

Lower interest rates – Lower interest rates reduce the cost of borrowing and so encourages spending and investment.

In 2008, base rates were cut to 0.5% to try and stimulate economic growth.

Increased wages. Higher real wages increase disposable income and encourages consumer spending.

Increased government spending (G).

Fall in value of sterling which makes exports cheaper and increases quantity of exports(X).

Increased consumer confidence, which encourages spending (C).

Lower income tax which increases disposable income of consumers and increases consumer spending (C).

Rising house prices, which create a positive wealth effect and encourages homeowners to spend more.

2. Long Term Economic Growth.

This requires an increase in the long run aggregate supply (productive capacity) as well as AD.

Diagram showing Long Run Economic Growth

 

LRAS or potential growth can increase for the following reasons:

1. Increased capital. e.g. investment in new factories or investment in infrastructure, such as roads and telephones.

2. Increase in working population, e.g. through immigration, higher birth rate.

3. Increase in Labour productivity, through better education and training or improved technology.

more on labour productivity

4. Discovering new raw materials.

5. Technological improvements to improve the productivity of capital and labour e.g. Microcomputers and the internet have both contributed to increased economic growth.

 

 Graph Showing Annual Growth in UK

In 2009, the sharp fall in Real GDP (negative economic growth) was caused by:

Higher oil prices reducing living standards.

Global credit crunch leading to a fall in bank lending and investment.

Fall in house prices causing lower wealth and spending.

Fall in consumer confidence related to banking crisis.

Different Views on Economic Growth

Classical Economists argue that an increase in AD will only increase Real GDP in the short term. They argue that the LRAS is inelastic therefore higher AD only causes inflation. Classical economists stress the role of supply side policies in increasing economic growth.

This is disputed by Keynesians. They believe the LRAS can be elastic, e.g. in a recession and therefore increasing AD may be quite important..

Causes of Recessions

A recession implies a fall in real GDP. An official  definition of a recession  is a period of negative economic growth for two consequative quarters.

Recession of 2009

 

This graph shows negative economic growth between Q3 2008 and early 2010.

 

Main Causes of Recession

1. Demand Side Shock

Factors that can cause a fall in aggregate demand:

Higher interest rates which reduce borrowing and investment

Falling real wages

Falling consumer confidence

Credit crunch which causes a decline in bank lending and therefore lower investment.

A period of deflation. Falling prices often encourage people to delay spending. Also deflation increases the real value of debt causing debtors to be worse off.

Appreciation in exchange rate which makes exports expensive and reduces demand for exports.

2. Supply Side Shock

Higher oil prices would increase thecost of production and causes the short run aggregate supply curve to shift to the left.

This supply side shock causes lower real GDP and higher inflation. This is difficult to solve with monetary policy - because we have both inflation and lower output to try and solve. (Changing interest rates can't do both at once.)

 

Examples of Recessions in UK

 

Causes of Great Depression 1930-32

Stock market crash causing financial turmoil and decline in confidence

Fall in trade due to global nature of downturn.

Adherence to gold standard and overvalued exchange rate until 1931

Deflationary fiscal policy (higher taxes, lower spending) worsened situation

More detail at causes of great depression

 

Causes of 1981 Recession

 

1981 recession was caused by:

1. High value of the pound which made exports more expensive and reduced demand for exports. This recession particularly impacted on British manufacturing.

2. High interest rates. In 1979, inflation in the UK was over 15%. The new Conservative governmet was committed to reducing high inflation they inherited. They pursued a tight monetary policy (higher interest rates) and tight fiscal policy (higher taxes, lower government spending. This reduced inflation but at a cost of falling spending, investment and output.

3. Tight Fiscal Policy. To control inflation the government were committed to reducing the levels of Government borrowing. This was influenced from Monetarist beliefs that controlling excess government borrowing was essential to the economy. Therefore the government increased taxes which reduced the disposable income of consumers and therefore reduced consumer spending.

more on 1981 recession

 

Causes of 1991 Recession

1. BOOM and BUST. In the 1980s economic growth was too fast and unsustainable therefore inflation increased to over 10% (see: Lawson boom). To reduce this inflation the government increased interest rates which lowered spending.

2. Joining the Exchange Rate Mechanism. The government became committed to maintaining a high value of the pound. This required high interest rates of up to 15%, which caused a big fall in aggregate demand. Also, because the pound was overvalued, exports were expensive causing less demand for UK exports.

3. High interest rates increased the cost of mortgage interest payments. Many were forced to sell. This caused a fall in house prices. Falling house prices caused a decline in consumer wealth and lower confidence. This also caused lower spending.

more on: 1991 recession

Causes Recession of 2008/09

Credit crunch - shortage of finance (Credit Crunch explained)

Falling house prices - related to shortage of mortgages and credit crunch

Cost push inflation squeezing incomes and reducing disposable income

Collapse in confidence of finance sector causing lower confidence amongst 'real economy'

Costs Of Economic Growth

· Despite the benefits of economic growth there are potential costs.· These costs will be greater if the rate of economic growth is too fast.

1. Inflation. If AD increases faster than AS then economic growth will be unsustainable. The output gap will narrow causing inflation to increase.

2. Boom and Bust Economic Cycles. If Economic growth is unsustainable then high inflationary growth may be followed by a recession. This occurred in the late 1980s and early 1990s. 

 

In the 1980s there was an economic boom with growth of over 5% a year. However this caused inflation to rise to over 10%. To reduce inflation the government increased interest rates, this caused the economy to slow down and then enter into a recession.

However if economic growth is at a sustainable rate this will not occur . For example, between 1993 and 2007, both economic growth and inflation were at a sustainable rate.

3. Balance Of Payments Deficit. Increased Economic growth causes an increase in spending on imports therefore causing a deficit on the current account.

This shows that in the 1980s boom, there was an increasing deficit in the balance of goods and services. In the recession of 1991, there was an improvement in the current account.

4. Environmental Costs. Increased economic growth will lead to increased output and therefore increased pollution and congestion. This will cause health problems such as asthma and therefore will reduce the quality of life

5. Reduced Inequality. Higher rates of economic growth have often resulted increased inequality, however this depends upon things such as tax rates and the nature of economic growth

 

The Great Depression

In the Great Depression the response of classical economists was to cut govt spending such as unemployment benefits to try and balance the budget. However the effect of this was to reduce AD further.

Keynes argued that in order to help the economy it was necessary for the govt to kick start the economy by injecting money into the economy. Keynes argued for public work

schemes which would employ those who were unemployed they would then be able to spend money which would create other jobs in the economy.

This would cause a budget deficit but it was necessary.

Unfortunately Keynes was largely ignored until after the war, leading to high unemployment until the Second World War

Ironically the countries who were most successful in overcoming the great depression were military dictatorships who spent significant amounts on military spending

Diagram Showing Recession

Paradox of Thrift:

In a recession Keynes noted that peoples psychology usually caused them to save more and spend less.

However this was exactly what the economy didn’t want, because it would reduce AD further. Therefore Keynes argued that it was the job of the govt to encourage people to spend.

Economic Recessions

A recession is defined as a period of time when the economy contracts (negative economic growth) for 2 consecutive quarters. A recession is characterised by

Lower Output

Lower investment

Higher Unemployment

Increased PSNCR

Lower Inflation

Graph of Recession

An official recession requires negative economic growth.:

However economists often state the economy is in a recession when growth is very slow. For example if growth was 0.1% this is much lower than potential growth (2.5% in the UK) therefore an output gap would occur and higher unemployment may well result.

This is sometimes known as a growth recession.

The Great Depression of the 1930s was the longest lasting recession in the UK there was negative economic growth for many years and unemployment averaged over 20% of the workforce. In some areas unemployment was over 75%

The UK has experienced recession in 1980-82 and 1991-92

Economic Trade Cycle

The economic trade cycle shows how economic growth can fluctuate within different phases, for example:

i) a boom (which is high growth causing inflation)

ii) Peak (top of trade cycle)

iii) Downturn or Recession ( fall in economic output)

iv) Recovery (upturn of economic growth)

Quarterly Economic Growth in the UK

Causes of Trade Cycle

1. Momentum effect. When there is positive economic growth, this tends to cause:

A rise in consumer and business confidence

Rising asset prices such as houses; this causes a rise in wealth and consumer spending.

Interest Rate Changes. When there is higher economic growth, inflation tends to rise. In response, Central Banks tend to increase interest rates to reduce growth and inflation.

Technology. Improvements in technology may cause a boost in economic growth. A lull in technological innovation may cause slower growth.

Political Business cycle. Some economists suggest that there is a political business cycle. This is when politicians try to have a boom (high economic growth) before an election to help win the election.

Global Trade Cycle. A global economic downturn will tend to affect individual economies.

Influencing the Trade Cycle

Some economists feel that there is an inevitability of a trade cycle and the government cannot influence and prevent recessions. However, other economists (such as Keynesians) argue that government intervention can help overcome recessions.

See: Fiscal Policy

1. Are recessions avoidable?

Between 1997 and 2007 the trade cycle was more stable in the UK. However, the global financial crisis pushed the UK economy into recession during 2008/09.

Output Gap

If potential output grows faster than actual output there will be an increase in spare capacity, the shortfall between actual and potential output increase.

With fast economic growth and increases in AD then the output gap gets smaller

The Long Run Trend Rate of Economic Growth:

This refers to the average sustainable rate of economic growth in an economy. For example in the UK this is about 2.5%. This depends on the growth of AS and productive capacity.