I am interested in writing about economic growth. This topic is so timely because the economy of US was reported to grow in the third quarter of this year. The growth in the economy was due to increases in inventories and export, thereby raising the gross domestic product to 2.7% during the third quarter.
Economic growth is a very important indicator of the economy as it signifies increase in the productive capacity of the country over time that leads to increases in national output and income. It is the increase in the total output of a country over time and is measured as the annual rate of increase in the country’s real GDP. Actually economic growth can be measured as the increase in real GDP over time or as the increase in real GDP per capita over time.
My understanding of economic growth is like this: it occurs when people allocate resources in some ways that gives more value to the resources. The simplest illustration is that of cooking a sumptuous meal in the kitchen. A person mixes ingredients using the most appropriate recipe to convert the limited quantity of inexpensive ingredients into the good tasting meal taking into account the pollution and nuisance generated in cooking. Economic growth is realized when better recipe is used that generates the best meal with fewer side effects. The same applies to the aggregate economy. Given the country’s limited scarce resources, increase in the national output over time can be achieved by using the most efficient technique of converting the resources to the most valuable output of the economy. One of the visible proof that the country is experiencing economic growth is the improvement in the standard of living of the people in the economy. That is to say, economic growth makes people in the economy better off.
As I understood the concept of gross domestic product, it is the total income of the economy that is earned domestically (and it includes the income earned by foreign-owned factors of production!). GDP is considered as the best measure of economic well-being since it is a measure of income as well as expenditure. The real GDP in particular is a measure of the country’s ability to satisfy the needs and desires of its citizens. I learned from the basics of national income accounting that GDP is comprised of the consumption spending of households, the investment spending of firms/companies, the spending of the government, and net exports or the export less imports. Also, it can be computed as the sum of the output of all the producing sectors of the economy. But the idea is very simple: GDP is the measure of the country’s output, of expenditure, and of income.
I mentioned earlier that the factors that lift the economy by 2.7% in the 3rd quarter of 2012 are the increased in inventories by businesses and exports. The reason for the growth is very obvious. As the simple national accounting had taught me, increase in business spending (like increasing stocks of goods on hand) and exports directly increase GDP. John Maynard Keynes even had a graphical illustration of the manner changes in expenditures leads to changes in GDP. According to this economists who said that “in the long run, we are all dead,” an increase in investment spending by business raises the aggregate demand which then increase output with multiplier effect (that is, the change in output or GDP is more than the increase in business spending!).
Speaking of the long run, since economic growth reflects the improvement in the production capacity of the country over time (in the long run), it is the determinant of the standard of living of the people in the economy. Changes or fluctuations in aggregate demand significantly affect the amount of goods and services produced in the economy in the short run.
What are the factors that influence GDP growth? There are three importance components of economic growth, namely capital accumulation, population growth and technological progress, that is, GDP depends on capital and labor, and on technology to convert capital and labor into output. Moreover, GDP grows when the factors of production increase or when the available technology improves. The capital actually pertains to investments that improve the quality of existing physical and human resources.
What’s even more interesting is the link between economic growth and budget deficit. Budget deficit can be simply understood as the shortfall of tax revenue from government spending; that is, the government is spending more than what it is earning from tax revenue. Normally, governments finance the deficit by borrowing in the bond market. And how will this affect the economy? When the government runs a budget deficit, public savings is negative and national savings is reduced. When the government borrows in the bond market to finance the deficit, the supply of loanable funds (also used to finance investments of firms and households) is reduced. As a result, the interest rate rises. As I understand it, higher interest rate tends to discourage borrowing (households will chose not to borrow to build new homes; firms will not borrow to build new factories). Generally, the government’s borrowing in the bond market to finance the deficit lowers private investment. This is the famous crowding out.
When deficits accumulate over time, it’s called the national debt. Higher national debt has a potential negative effect on the economy’s net national worth. For one, debt financing tend to increase the interest rate that in turn, reduces investment. With lower capital stock, output will also be lower. Second, not only that the increase in national debt can reduce the capital but it can also increase the nation’s external debt. With these problems, the best way to reduce the national debt is through economic growth.
I have mentioned above about the effect of aggregate demand on the level of GDP. In this part, a little learning about GDP and GNP is tackled. The Gross National Product or GNP takes into account the total income of all residents of a nation, including the income from factors of production used abroad; it can also be understood as the total expenditure on the nation’s output of goods and services. Meanwhile, the Gross Domestic Product or GDP refers to the total income earned domestically, including the income earned by foreign-owned factors of production; alternatively, it is the total expenditure on domestically produced goods and services. What is accounted as part of GDP and what is accounted in GNP? In the case of a Japanese-owned factory operating in Mexico, the value of the final goods produced by the factory is accounted as part of Mexico’s GDP; and also accounted in Japan’s GNP.
Between GNP and GDP, the latter is a reasonably accurate and very useful indicator of a country’s economic performance. Nevertheless it has certain limitations which include failure to take into account for nonmarket or illegal transactions, changes in leisure and in product quality, the composition and distribution of output, and the environmental effects of production.
Fiscal policy has several effects on the economy. The expansionary fiscal policy (either an increase in government spending or tax cut) is normally exercised during periods of low output or recession. Obviously, the primary goal is to pump prime the economy. On the one hand, the increase in government spending has direct proportional effect on the aggregate demand and has multiplier magnifies the effect of spending resulting to a greater increase in level of national output (or GDP).
On the other hand, a tax cut can also be used as a discretionary fiscal policy tool. A tax cut do not directly affect aggregate demand but impacts consumption spending (disposable income increases with a tax cut!). The corresponding increase in consumption spending due to a tax cut leads to increase in aggregate demand that in turn affects GDP. Generally, expansionary fiscal policy stimulates demand in the economy that eventually increases GDP.
Further, fiscal policy is also used when the economy experiences inflationary pressure (e.g., occurrence of demand-pull inflation). The contractionary fiscal policy (through decrease in spending or increase in tax) may help in controlling demand-pull inflation – or an inflation that is caused by the increase in aggregate demand. Intuitively, such policy slows down economic activity, and therefore slows down the increase in the price level.
However, despite these fiscal policy solutions to stabilize the economy, certain flaws are also present. One is the problem of timing. There is the operational lag between the time fiscal action is taken and the time that action affects output, employment, or the price level; as result, the fiscal action become ineffective. Another lag is the so-called administrative lag. Usually it takes some time before policy-makers can take action on inflationary problem in the economy, perhaps partly due to the democratic structure of the government.
Another flaw that I could think of is the crowding out effect of expansionary fiscal policy. Crowding out of investment is likely to happen when the government uses expansionary fiscal policy that has the effect of increasing the interest rate that tends to lower private spending (reduced consumption due to increased savings; reduced investment due to higher interest rate). In the case of trading economies, it is also possible to happen that the budget deficit of the US results to the crowding out of investment spending in other countries like Germany or Britain. The budget deficit tends to lower the value of US dollar relative to Euro and the Pound. In effect, the prevailing interest rate in Germany or Britain will increase as a result of the more valuable currency. Higher interest rate leads to a decline in investment spending, hence the crowding out effect.
There is also the possibility for the economy to experience twin deficit. The unusual episodes of expansionary fiscal policy (through (personal income) tax cuts) in the US in the 1980s resulted to federal budget deficit. The deficit caused the reduction in the national savings that in turn lead to large trade deficit. This is the twin deficits or the double deficits. The argument for the twin deficit is that when the government cuts taxes, the disposable income of the domestic residents of the economy is increased; with the increased income, people increases consumption of goods and services (including foreign products). The rise in the consumption of foreign products leads to trade deficit (imports exceeding exports).
Moreover, economics in general have taught me that every decision involves a trade off. In a micro level, this concerns the behavior of an individual consumer to give up some boxes of milk for some pounds of meat. In the aggregate, this may involve the trade-off between inflation and unemployment. This is true in the short run. The government’s attempt to lower inflation has the effect of temporarily increasing the unemployment. The trade off exist because of the slow adjustment of some prices in the short run. One way of reducing inflation is by reducing the quantity of money in the economy. This tends to increase the interest rate, and then reduces private spending that in turn reduces aggregate demand, and therefore the level of prices. In a very simple sense of supply and demand, lower prices tends to discourage production, and low production implies low employment, hence the increase in unemployment. But then again, the trade off is only temporary.
Another trade off on the aggregate economy level is between economic efficiency and equity. Efficiency means that the society in general is getting the most it can from its available but limited resources; while equity is the fair distribution of economic resources among the members of the society. There are government policies that favors one from the other, hence the trade off. For instance, the government’s goal of redistributing income from the rich to the poor (prioritize equity) tend to reduce efficiency since the reward system becomes distorted and economic members are discourage to work productively.
These, generally, are the things that I have learned in macroeconomics.
