2.1 Growth

Question 1

What is Real GDP?

Answer 1

Real GDP stands for real Gross Domestic Product. It is the total value of all final goods and services produced in an economy at a given price level in a year, adjusted for inflation using constant prices.

Question 2

What is economic growth?

Answer 2

Economic growth refers to an increase in real GDP or an increase in the productive capacity of the economy.

Question 3

What are the benefits of using national income statistics, such as Real GDP?

Answer 3

1) National income statistics can be used as a report card for a country, allowing the analysis of an economy’s performance over time. This is useful for policymakers to see if their macroeconomic objective of increased growth is being met. 2) Governments can use national income statistics to enact and inform economic policy. They provide crucial information on output and living standards, allowing governments to implement policies such as demand-side policies or supply-side policies. National income statistics can also be used to evaluate the success of past policies. 3) Individuals, businesses, and governments can use national income statistics to build forecasting models and make informed decisions about investment and spending. 4) National income statistics can be used as a benchmark to evaluate standards of living, allowing comparisons between countries and determining the effectiveness of one country’s policies compared to another.

Question 4

Evaluation: What are the problems with using Real GDP as a measure of economic growth?

Answer 4

1) A large amount of data is needed to accurately measure GDP, which comes from varied sources, leading to inaccuracies in the data and often requiring revisions. 2) The informal economy, which includes unrecorded economic activity such as unlicensed businesses and illegal activities, is not included in official GDP figures, leading to understated figures. This can also impact unemployment figures and tax revenue collection.

Question 5

What is the problem of double counting in calculating Real GDP using the output method?

Answer 5

The problem of double counting arises when using the output method to calculate Real GDP as primary sector output, such as raw materials, are double counted once manufactured in the secondary sector. For example, when copper is sold as a raw material, it adds to Real GDP, but when it is manufactured into wiring in the secondary sector, the value of the raw material is calculated again in the price of the wiring. To overcome this problem, the final value of all goods and services is measured to calculate Real GDP.

Question 6

What is the problem with using Real GDP as a measure of living standards?

Answer 6

Real GDP is a single measure of living standards, only measuring changes in income, and does not take into account factors such as health, education, infrastructure, the environment, gender equality, and freedom.

Question 7

What is the problem with GDP as a measure of living standards in terms of externalities?

Answer 7

GDP only accounts for the quantity of output produced, providing no information regarding the quality of that output. Production can lead to severe negative externalities such as air pollution, resource degradation, deforestation, and biodiversity loss. These externalities drastically reduce living standards, but are not accounted for in GDP figures.

Question 8

How can we address the problem of negative externalities in GDP?

Answer 8

Green GDP can be used, where environmental costs of growth are subtracted from Real GDP, but this is politically sensitive and difficult to calculate accurately.

Question 9

What is the problem with Real GDP regarding the distribution of income?

Answer 9

Real GDP does not provide information regarding the distribution of income. Increases in Real GDP per capita may only benefit the elite or a small part of the population, as growth may have been generated from one dominant sector, or capital owners benefit from higher incomes. Corruption may also prevent effective redistribution of income, promoting income inequality in society.

Question 10

Can the composition of output produced affect living standards?

Answer 10

Yes, the composition of output produced may not provide an immediate boost to living standards, such as an increase in capital goods or defence-related goods being produced.

Question 11

Why is using nominal exchange rates problematic for comparing Real GDP between countries?

Answer 11

Nominal exchange rates are used rather than real exchange rates that adjust for changes in purchasing power between countries. For example, India has a lower GDP per capita than the USA, but goods/services are much cheaper in India. In real terms, incomes in India can stretch further in purchasing the same basket of goods/services than in the USA. Real GDP per capita data must be calculated using purchasing power parity (PPP) adjusted exchange rates to get a real comparison of living standards between countries.

Question 12

What is the flaw in using Real GDP as a measure of living standards in regards to remittance income?

Answer 12

Real GDP does not take account of remittance income, which is income earned abroad by domestic workers and sent back to family members in the home country. Remittance income provides a boost to family income in the domestic country but is not calculated in a country’s GDP, despite being generated by that country’s factor of production.

Question 13

What is the problem with Real GDP in regards to MNC profit?

Answer 13

Real GDP can misguide an increase in living standards by including profit made by MNCs, which is often repatriated back to the home country and not used to increase living standards in the country where they are located. MNCs may also impose poor working conditions and low pay on their workers, increasing incomes for managers, directors, and shareholders but not individual workers.

Question 14

What is GNI and how does it address the problems with Real GDP?

Answer 14

GNI is gross national income and accounts for only the income generated by a country’s factors of production regardless of where they are located. Remittance income is included, while MNC profit is not. For developing countries, GNI per capita is a preferred measure of living standards than GDP.

Question 15

Causes of Short Run Economic Growth

Diagram

Answer 15

Question 16

How can the government increase short-run economic growth by increasing government spending?

Answer 16

The government can boost spending in the economy, such as on infrastructure, education, healthcare, and public sector wages. As G is a core component of AD, this will significantly increase AD from AD1 to AD2 and generate a large multiplier effect in the economy, leading to further rounds of spending and income generation.

Question 17

How does reducing corporation tax affect the economy?

Answer 17

Reducing corporation tax increases the incentive for firms to invest. Firms have a greater level of retained profit to fund investment, which involves spending on new capital, upgrading machinery, building a new factory, improving technology, engaging in research and development and spending on innovation. This investment improves both the quantity and the quality of the capital stock in the economy whilst also improving the productive efficiency of the economy, increasing LAS from LRAS1 to LRAS2.

Question 18

What is the effect of a cut in interest rates on short-run economic growth?

Answer 18

A cut in interest rates will reduce the cost of borrowing, making it cheaper for consumers to borrow and increasing consumption in the AD equation. This shifts AD to the right from AD1 to AD2, leading to short-run economic growth.

Question 19

What is privatisation, and how does it affect the economy?

Answer 19

Privatisation of industries creates a profit motive in the industry, incentivizing more firms to enter the market and increasing competition. Competition and the profit maximisation objective incentivises maximum efficiency where firms aim to lower their costs of production as much as possible to charge lower prices than rivals. This increases the productive efficiency of the economy, increasing LRAS from LRAS1 to LRAS2.

Question 20

How can government spending on education increase productive potential and reduce structural unemployment?

Answer 20

Government spending on education, such as apprenticeship schemes, adult re-training, and school curriculum reform, can improve the skills and productivity of the labor force, raising human capital. This reduces structural unemployment by providing skills to fill job vacancies in the economy, increasing the quality of labor and thus LAS from LRAS1 to LRAS2.

Question 21

How does a cut in interest rates affect short-run economic growth?

Answer 21

A cut in interest rates reduces the cost of borrowing, reducing the incentive to save and increasing consumer spending. This increases consumption in the AD equation, shifting AD to the right from AD1 to AD2. It also reduces monthly payments for those with tracker or variable rate mortgages, increasing disposable income and boosting consumption. Lastly, it reduces the cost of borrowing for firms, making it easier for them to finance investment and increasing the marginal propensity to invest, which also increases AD.

Question 22

How can the government increase short-run economic growth by increasing disposable income for those on lower incomes?

Answer 22

The government could reduce the marginal rate of income tax for those in lower income tax bands or increase the income tax-free allowance. This would increase disposable income for those on lower incomes, who have a higher marginal propensity to consume, leading to an increase in consumption in the economy and a shift in AD to the right from AD1 to AD2.

Question 23

How can the government increase short-run economic growth by increasing retained profits for businesses?

Answer 23

The government can reduce the level of corporation tax, which increases retained profits for businesses, making it easier for them to finance investment and increasing the marginal propensity to invest. As investment increases, AD will increase from AD1 to AD2, as I is a component of AD.

Question 24

How does increased demand lead to actual economic growth?

Answer 24

Increased demand leads to actual growth by firms responding with increased output and exhausting spare capacity, bringing output closer to the full employment level of output. This increase in output is an increase in real GDP, which is an increase in economic growth, from VI to Y2.

Question 25

How can the government increase short-run economic growth by weakening the exchange rate?

Answer 25

The government can weaken the exchange rate by reducing interest rates, increasing the money supply, or selling domestic currency reserves. This makes exports cheaper and imports dearer, leading to an improvement in the trade balance of the current account and reducing a current account deficit or moving it to surplus. As (X-M) is a component of aggregate demand, AD will increase from AD1 to AD2.

Question 26

Causes of Long Run Economic Growth

Diagram

Answer 26

Question 27

How can government spending on infrastructure increase productive efficiency and competitiveness?

Answer 27

Government spending on infrastructure, such as transport infrastructure (improving roads, building new roads, airports, ports, runways, train lines, and rail electrification), reduces costs of production for firms as transporting goods and services around the country and internationally becomes quicker, easier, and more efficient. This increases the productive efficiency of the economy while also boosting competitiveness, increasing LAS from LRAS1 to LRAS2.

Question 28

How does government spending on infrastructure increase the productive potential of the economy?

Answer 28

Government spending on infrastructure increases the quantity and quality of the capital stock of the economy, for example, by building new schools, hospitals, railway lines, roads, and electricity infrastructure. This increases LAS from LRAS1 to LAS2 and thus boosts the productive potential of the economy.

Question 29

How can subsidies or tax allowances increase the productive efficiency of the economy?

Answer 29

Governments can offer subsidies or tax allowances to increase the incentive for firms to invest in new capital, upgrading machinery, building a new factory, improving technology, engaging in research and development, and spending on innovation. Such investment improves both the quantity and the quality of the capital stock in the economy while also improving the productive efficiency of the economy, increasing LAS from LRAS1 to LRAS2.

Question 30

How does reducing the marginal rate of income tax increase the productive potential of the economy?

Answer 30

Reducing income taxes increases the incentive to work harder as less income will be taxed away when earned, increasing the productivity of labor. Furthermore, lower income taxes provide an incentive for those of working age currently inactive in society to start working and take available jobs, entering the labor force. These factors increase both the quantity and quality of the labor force, increasing LAS from LRAS1 to LRAS2.

Question 31

What is the effect of government spending on education on the economy?

Answer 31

Government spending on education can improve the skills and therefore productivity of the labour force, raising human capital. This reduces structural unemployment by providing skills to fill job vacancies in the economy, increasing the quality of labour and thus LAS from LRAS1 to LRAS2.

Question 32

What is deregulation, and how does it affect the economy?

Answer 32

Deregulation involves reducing laws and government imposed standards in the economy. This significantly reduces the costs of production for firms. At the same time the legal barriers to entry into a market are reduced, increasing competition and incentivizing maximum efficiency as firms look to remain competitive. Both factors improve the productive efficiency of the economy, increasing LAS from LRAS1 to LRAS2.

Question 33

What is trade liberalisation, and how does it affect the economy?

Answer 33

Trade liberalisation involves the removal of trade barriers such as tariffs and quotas, freeing up trade promoting global competition. The fierce and intense nature of global competition forces producers to do whatever they can to compete. Competition and the profit maximisation objective incentivises maximum efficiency where firms aim to lower their costs of production as much as possible to charge lower prices than rivals. This increases the productive efficiency of the economy, increasing LAS from LRAS1 to LRAS2.

Question 34

Causes of Recession - Demand Side Shocks

Answer 34

Question 35

What is a demand side shock that can cause a recession?

Housing or Stock Market crash

Answer 35

A sudden fall in consumption, caused by a housing or a stock market crash where consumers feel less wealthy, acts as a negative demand side shock and drastically reduces AD. This fall in consumption shifts the AD curve to the left from AD1 to AD2, taking an economy that may have been growing steadily and operating close to full employment to an equilibrium where vast spare capacity exists depressing the price level from P1 to P2. The result is a reduction in economic growth from YI to Y2, potentially a recession, because with less demand in the economy, firms react by reducing production of goods and services. This fall in production is a fall in Real GDP, hence reducing growth.

Question 36

What is another demand side shock that can cause a recession?

Sudden fall in investment

Answer 36

A sudden fall in investment. This could be because firms foresee a reduction in the growth rate in the economy and hold back on purchasing capital machinery and business expansion. If the growth rate is expected to slow, firms don’t need to expand if demand and therefore profitability is likely to be lower. This fall in investment can severely reduce AD as investment is a component of AD, reducing economic growth from Y1 to Y2.

Question 37

What is a third demand side shock that can cause a recession?

Fall in spending by foreigners

Answer 37

A sudden fall in spending by foreigners on domestic goods and services (exports) can reduce export revenues and take an economy into a recession. This shifts AD to the left from AD1 to AD2 as net exports are a component of AD, reducing growth from Y1 to Y2. Furthermore, a strong exchange rate makes exports dearer and imports cheaper, leading to an increase in the demand for imports and a decrease in the demand for exports. This effect worsens the trade balance of the current account, which is a component of aggregate demand, leading to a reduction in economic growth.

Question 38

What are some benefits of economic growth?

Answer 38

Economic growth brings about a fall in unemployment as firms need more workers to produce extra output in response to high demand for goods and services, thus increasing both material and non-material standards of living. It also leads to higher profits for firms due to more demand and higher household incomes in the economy, increasing their revenues and profitability. With greater levels of economic growth, tax revenues collected from income tax, corporation tax and expenditure taxes like VAT will rise, leading to a fiscal dividend for the government. The government will have more money to spend on important public services in the economy such as education and healthcare, which can improve welfare payments to those in need, helping to reduce income inequality and enable both short run and long run growth to persist over time.

Question 39

What is a supply side shock that can cause a recession?

a sudden increase in the price of oil

Answer 39

A sudden increase in the price of oil, which is a key factor of production for an economy, can increase the costs of production for firms, shifting the SRAS curve to the left from SRAS1 to SRAS2. Consequently, cost push inflation increases in the economy from P1 to P2, and growth in the economy reduces from Y to Y2, potentially causing a recession but even worse stagflation, which is stagnant or decreasing growth with higher than target inflation.

Question 40

What is a catastrophic demand side shock that can cause a recession?

bankinng or financial crisis

Answer 40

A banking or financial crisis would be a catastrophic demand side shock to an economy, especially with integrated globalized banking systems in the world economy. This is because banks are important financial intermediaries that bring savers and borrowers together. If banks fail due to a financial crisis, for example, it means there will be less lending to individuals and firms to facilitate consumer spending and investment. Decreasing C and I in the AD equation will reduce AD from AD1 to AD2 and could lead to a recession in the economy with economic growth decreasing from Y1 to Y2.

Question 41

What is a supply side shock and how does it affect economic growth?

Increase in business taxes like VAT

Answer 41

A supply side shock occurs when there is a sudden increase in the costs of production for firms due to factors such as a rise in oil prices or an increase in business taxes like VAT, shifting the short run aggregate supply (SRAS) curve to the left from SRAS1 to SRAS2. This leads to cost push inflation in the economy from P1 to P2 and reduces growth in the economy from Y1 to Y2, potentially causing a recession or even worse stagflation, which is stagnant or decreasing growth with higher than target inflation.

Question 42

What is demand-pull inflation and how can unrestrained economic growth lead to it?

Costs of Econhomic Growth

Answer 42

Demand-pull inflation occurs when aggregate demand increases faster than aggregate supply, putting pressure on existing factors of production and increasing their prices, which leads to higher prices of goods and services throughout the economy. Unrestrained economic growth can lead to demand-pull inflation because if the aggregate demand is increasing faster than the aggregate supply, excessive pressure will be placed on existing factors of production, leading to higher prices of goods and services throughout the economy.

Question 43

What is the problem with using Real GDP to measure economic growth?

Costs of Economic Growth

Answer 43

Real GDP only accounts for the quantity of output produced and provides no information regarding the quality of that output. This is problematic because production can lead to severe negative production externalities such as air pollution, resource degradation, resource depletion, deforestation, and a loss of biodiversity, which drastically reduces living standards, but these externalities are not accounted for in the GDP figures.

Question 44

Why doesn’t economic growth necessarily mean that incomes are increasing for all in society?

Costs of Economic Growth

Answer 44

Economic growth does not necessarily mean that incomes are increasing for all in society because growth may have been generated from one dominant sector in the economy, where only those who work in that sector benefit from higher incomes, or growth may have been capital intensive, where only capital owners benefit from higher incomes. Additionally, corrupt governments may prevent effective redistribution of income from higher levels of GDP and increases in tax revenue, promoting income inequality in society. As a result, the poor may see no improvements in their standards of living at all, and relative or absolute poverty will remain or even increase.

Question 45

What are the factors besides income that contribute to living standards, and how should economic growth translate into more for there to be a conclusive rise in living standards?

Costs of Economic Growth

Answer 45

Besides income, factors such as health and education, infrastructure, the environment, gender equality, and freedom contribute to living standards. Economic growth must translate into more to conclusively improve living standards. Composite indicators such as the Human Development Index (HDI) should be used alongside Real GDP to see whether increases in economic growth actually translate into higher living standards.

Question 46

What are the three key criteria for evaluating economic growth?

Evaluation of Economic Growth

Answer 46

The three key criteria for evaluating economic growth are sustainability, inclusivity, and sustained growth. Sustainable economic growth is growth without excessive inflationary pressure, growth without significant environmental costs, and growth without the risk of resource depletion. Inclusive economic growth benefits all citizens in the economy, not just the elite. To achieve inclusive growth, transparent, accountable, and non-corrupt governments must exist to collect taxes efficiently and redistribute these revenues to where they will have the most benefit in improving the distribution of income and living standards for all. Sustained economic growth means that growth continues to increase over time without sharp contractions, with balanced growth occurring from both the demand and supply side to ensure that any shocks can be absorbed with other avenues available to keep growth strong and living standards increasing.