Chapter 22 - Economic Growth

Question 1

What is long run economic growth?

Answer 1

The expansion of the productive capacity of an economy.

Question 2

What is short run economic growth?

Answer 2

An increase in actual GDP.

It is where aggregate output increases in the short run in response to an increase in aggregate demand or an improvement in utilisation of the factors of production — for example, when unemployment falls. This is measured in terms of the rate of change of gross domestic product (GDP).

Question 3

What is the policy objective of economic growth?

Answer 3

Expanding the availability of resources in an economy enables the standard of living in the country to increase. In the industrial economies, populations have come to expect steady improvements in incomes and resources. The economy’s performance in terms of expansion of resources is a key indicator of success in macroeconomic policy, which explains why the media and politicians monitor it so closely.

Therefore for any society, economic growth is likely to be seen as a fundamental objective - perhaps even the most important one, as it could be argued that other policy objectives are subsidiary to the growth target. In other words, the control of inflation and the maintenance of full employment are seen as important short-run objectives, because their achievement facilitates long-run economic growth.

Question 4

What is a nominal value?

Answer 4

Value of an economic variable based on current prices, taking no account of changing prices through time.

Question 5

What is a real value?

Answer 5

Value of an economic variable, taking account of changing prices through time.

Question 6

What is real GDP?

Answer 6

GDP at constant prices, taking account of changing prices through time.

Question 7

What is nominal GDP?

Answer 7

GDP at current prices, taking no account of changing prices through time.

Question 8

How do we calculate price index?

Answer 8

(Nominal GDP / Real GDP) * 100

Question 9

What is gross national income (GNI)?

Answer 9

GDP plus net income from abroad

Question 10

How does GDP work?

Answer 10

GDP is a way of measuring the total output of an economy over a period of time, and its rate of change is used as a measure of economic growth. Although real GDP can provide an indicator of the quantity of resources available to citizens of a country in a given period, as an assessment of the standard of living it has its critics.

GDP focuses on the domestic economy. However, it is also important to recognise that residents of the economy also receive some income from abroad — and some income earned in the domestic economy is sent abroad. Gross national income (GNI) takes into account these income flows between countries, and for some purposes is a more helpful measure — indeed, this is the standard measure used by the World Bank to compare average incomes across countries. This measure was formerly known as gross national product (GNP).

Question 11

What is seasonal adjustment?

Answer 11

A process by which seasonal fluctuations in a variable are smoothed to reveal the underlying trend.

Question 12

What is GDP per capita and how do we calculate it?

Answer 12

The average level of GDP per head of population.

It is calculated by GDP / population

Question 13

How does short run economic growth work?

Answer 13

Economic growth is possible in the short run if the economy is operating below full employment, so that utilisation of factors of production can be increased. This would be represented by a movement to the PPC from a position within it.

Such short-run growth could be initiated by an increase in aggregate demand, which could be the result of an increase in its components (consumption, government expenditure, net exports or investment), or by tax cuts. The move could also be the result of an increase in short-run aggregate supply.

Notice that of these changes, only investment (perhaps encouraged by lower interest rates) affects long-run aggregate supply. If the economy begins at full employment, the increase in aggregate demand only enables short-run (actual) economic growth. In the longer term, the economy returns to the full employment level

Question 14

How does long run economic growth work?

Answer 14

At a basic level, production arises from the use of factors of production - capital, labour, enterprise and so on. Capacity output is reached when all factors of production are fully and efficiently utilised. From this perspective, long-run economic growth can come either from an increase in the quantity of the factors of production, or from an improvement in their efficiency or productivity.

Question 15

How does capital cause economic growth?

Answer 15

Capital is a critical factor in the production process. Therefore, an increase in capital input is one source of economic growth. In order for capital to accumulate and increase the capacity of the economy to produce, investment is needed.

In the national accounts, the closest measurement that economists have to investment is ‘gross fixed capital formation’. This covers net additions to the capital stock, but it also includes depreciation. However, it is the net addition to capital stock that generates an increase in productive capacity, enabling long-run economic growth.

Question 16

How does technology cause economic growth?

Answer 16

The contribution of capital to growth is reinforced by technological progress, as the productivity of new capital is greater than that of old capital that is being phased out. For example, the speed and power of computers has increased enormously over recent years, which has had a great impact on productivity. Effectively, this means that technology is increasing the contribution that investment can make towards enlarging capacity output in an economy. Innovation can also be important, through the invention of new forms of capital and new ways of using existing capital, both of which can contribute to economic growth.

Question 17

What is productivity?

Answer 17

Measure of the efficiency of a factor of production

Question 18

What is labour productivity?

Answer 18

Measure of output per worker, or output per hour worked

Question 19

What is capital productivity?

Answer 19

Measure of output per unit of capital

Question 20

What is total factor productivity?

Answer 20

The average productivity of all factors, measured as the total output divided by the total amount of inputs used

Question 21

What is human capital?

Answer 21

The stock of skills and expertise that contribute to a worker’s productivity, which can be increased through education and training

Question 22

How does efficiency cause economic growth?

Answer 22

Productivity is a measure of the efficiency of a factor of production. For example, labour productivity measures output per worker, or output per hour worked. The latter is the more helpful measure, as total output is affected by the number of hours worked, which does vary somewhat across countries. Capital productivity measures output per unit of capital. Total factor productivity refers to the average productivity of all factors, measured as the total output divided by the total amount of inputs used.

An increase in productivity raises aggregate supply and the potential capacity output of an economy, and so contributes to economic growth.

Question 23

How does labour cause economic growth?

Answer 23

Capital has sometimes been seen as the main driver of growth, but labour too has a key contribution to make. There is little point in installing a lot of high-tech equipment unless there is the skilled labour to operate it. There is relatively little scope for increasing the size of the labour force in a country, except through international migration. The quality of labour input is more amenable to policy action. Education and training can improve the productivity of workers, and can be regarded as a form of investment in human capital.

Education and healthcare may have associated externalities. In particular, individuals may not perceive the full social benefits associated with education, training and certain kinds of healthcare, and therefore may choose to invest less in these forms of human capital than is desirable from the perspective of society as a whole. Another such externality is the impact of human capital formation on economic growth as a justification for viewing education and healthcare as merit goods. For many developing countries, the provision of healthcare and improved nutrition can be seen as additional forms of investment in human capital, since such investment can lead to future improvements in productivity.

Question 24

What is the economic cycle?

Answer 24

A phenomenon whereby GDP fluctuates around its underlying trend, following a regular pattern

Question 25

How does the economic cycle work?

Answer 25

GDP fluctuates through time around an upward trend. At any point in time, GDP may be below or above its trend (full employment) value, the difference being known as the output gap. This is defined as the actual level of output minus the potential level. If the economy is in recession, with actual GDP below the full employment GDP, then the gap is negative. If actual GDP is above the trend level, the gap is positive. This process reinforces the important distinction between growth in the short run, and growth in the long run. The term long-run economic growth is used to refer to the process by which there is an increase in the trend, or potential, rate of growth of GDP: in other words, when there is an increase in long-run aggregate supply - an increase in the productive capacity of the economy. Indeed, this is the process by which GDP is able to follow an upward trend over time as productive capacity increases. However, there are also short-run changes in the actual level of GDP, so there will be an observed increase in real GDP. This is short-run economic growth, and is not to be confused with the changing capacity of the economy through time. This short-run economic growth can occur (for example) because unemployed factors of production are being drawn into use when the economy is recovering or in boom. From a policy perspective, it is important to know at what stage the economy is located. When the output gap is negative, and the level of output is below trend, then it may be tempting for policy-makers to try to 'fill the gap' by stimulating aggregate demand. However, this would be dangerous when the output gap is positive, as the main effect would be on the price level.

Question 26

What is a recession?

Answer 26

A situation in which a economy's real GDP falls in 2 consecutive quarters

Question 27

What are the benefits and costs of economic growth?

Answer 27

Economic growth in the long run entails an expansion of productive capacity, which in turn expands the resources available within the country. This means that standards of living can improve, together with levels of healthcare provision and educational opportunities. This is the fundamental benefit of economic growth, allowing the country's population to enjoy better living conditions and hopefully improving people's morale. Growth can also mean higher employment, or improved employment opportunities and working conditions. People may also benefit from an improved environment and from advancing technology. From the government's perspective, tax revenues may increase, allowing higher expenditure that further adds to the improvements in living standards. Economic growth also brings costs, perhaps most obviously in terms of pollution and degradation of the environment. In designing long-term policy for economic growth, governments need to be aware of the need to maintain a good balance between enabling resources to increase and safeguarding the environment. Pollution reduces the quality of life, so pursuing economic growth without regard to this may be damaging. This means that it is important to consider the long-term effects of economic growth - it may even be important to consider the effects not only on today's generation of citizens but also on future generations. Although economic growth may expand the resources available, there is no guarantee that these will be evenly distributed among the population. If growth leads to higher concentration of income and wealth in a relatively small proportion of people, then inequality may increase. This may lead to increasing tension and even to civil conflict.

Question 28

How can the environment be seen as a factor of production?

Answer 28

One way of viewing the environment is as a factor of production that needs to be used effectively, just like any other factor of production. In other words, each country has a stock of environmental capital that needs to be utilised in the best possible way. However, if environmental capital is to be used appropriately, it must be given an appropriate value and this can be problematic. If property rights are not firmly established - as they are not in many less developed countries - it is difficult to enforce legislation to protect the environment. Furthermore, if the environment (as a factor of production) is under-priced, then firms will use 'too much' of it. There are externality effects at work here too, in the sense that the loss of biodiversity is a global loss, and not just something affecting the local economy. In some cases there have been international externality effects of a more direct kind, such as when forest fires in Indonesia caused the airport in Singapore to close down because of the resulting smoke haze.