4.

6 ECONOMIC GROWTH
DEFINITION OF ECONOMIC GROWTH
Economic growth is the annual increase in the level of national output — that is,
the annual percentage change in the country’s gross domestic product (GDP).
Gross Domestic Product (GDP) – total output produced in a country
Domestic – home country; product – output
Nominal gross domestic product (nominal GDP) measures the monetary value
of goods and services produced within a country during a given period of time,
usually one year.

Economic growth increases the long-term productive capacity of the economy -

shifts the production possibility curve outside. A combination of an increase in
the quantity and quality of factors of production shifts the PPC outwards from
PPC1 to PPC2, creating more producer and consumer goods in the economy.
3 methods of measuring output – income, output and expenditure – gives the
same figure because an output of 10 million USD gives rise to an income of 10
million USD which is spent on the output.
Circular flow of income

METHODS OF CALCULATING GDP

• Output method – summation of output produced by all industries in the
country. Problem of double counting – adding output twice – eg: tyre
used in car industry economists suggest value added by firm at every
stage of production
• Income method – income earned in producing the country’s output.
Transfer payments like pensions, unemployment benefits not included as
there is no output produced for these payments
• Expenditure method – all the expenditure on the country’s finished
output
GDP = C + I + G + (X-M)
➢ C - consumption expenditure - total spending on goods and
services by individuals and households in an economy
➢ I – investment expenditure - capital spending of firms used to
increase production and to expand the economy’s productive capacity –
spending on machinery
➢ G – government spending - total consumption and investment
expenditure of the government. Eg: spending on infrastructure such as
rail and road networks and on the construction of new schools and
hospitals.
Note: The calculation of government spending ignores payments made
to others without any corresponding output, such as unemployment
benefits
➢ (X – M) – net exports
MEASUREMENT OF ECONOMIC GROWTH
Nominal and Real GDP
Nominal GDP- GDP valued at current prices – not adjusted for inflation – if
price rises, nominal GDP also rises even if output does not change
Real GDP – takes into the effects of inflation - It reflects the true value of goods
and services produced in a given year because inflation artificially raises the
value of a country’s output
Real GDP = nominal GDP x price index in the base year/price index in the
current year
Price Index - A price index is a weighted average of the prices of a selected
basket of goods and services relative to their prices in some base-year. It is used
to indicate changes in the level of prices from one period to another
Eg: 2016 – nominal GDP – 800 billion USD
Price index - 100
2017 – nominal GDP – 900 billion USD
Price index – 110 (there is a 10% increase in the price of basket of goods and
services as compared to the prices in 2016)
Real GDP in 2017 = 900 * 100/110 = 818.18 billion USD
REAL GDP PER HEAD
Real GDP per head (or GDP per capita) measures the gross domestic product of
a country divided by its population size. This is a key measure of a country’s
economic growth and standards of living, as GDP per head indicates the mean
average national income per person.
Real GDP per capita = Real GDP / Population
Difficulty in measuring Real GDP – GDP could lessen the actual value of
output due to unrecorded economic activity and non-marketed goods and
services
Reasons for unrecorded economic activity:
• Small scale activity
• High costs of registration
• Illegal activities
Number of illegal activities, tax rates, penalties of tax evasion and
government regulation influence the size of unrecorded economic activity. It
reduces tax revenue.
Non-marketed goods and services – products not bought or sold –
individuals produce food for their own use, people who repair their own cars
RECESSION
Occurs when GDP falls for a period of 6 months (two consecutive quarters) or
more – output falls as compared to previous period.
CAUSES OF RECESSION
• Fall in aggregate demand (negative demand side shocks)
➢ lower levels of consumer and business confidence due to global
financial crisis or declining house prices in economy
➢ Fall in exports when exchange rate rises or when demand for
exports fall
➢ Fall in government expenditure
➢ High unemployment – causes fall in disposable income – fall in
consumption expenditure
➢ High interest rates - fall in investment expenditure

• Fall in aggregate supply (negative supply side shocks)

➢ Rise in fuel or raw materials cost

CONSEQUENCES OF RECESSION
• Low output – rises unemployment and reduces income – lowers living
standard
• Investment from abroad falls
• Fall in tax revenue, rise in government expenditure on unemployment
benefits – causes budget deficit or reduce budget surplus
• If recession is due to fall in aggregate supply, it could lead to inflation
CAUSES OF ECONOMIC GROWTH
SHORT RUN: an increase in aggregate demand due to cut in tax or increase
in consumer confidence – causes rise in output – if there are unused resources
in the economy, rise in output causes a movement from a point inside the PPC
to a point on the PPC.
LONG RUN: increase in quality (better education and training, advances in
technology) and quantity (capital investment, rise in labour supply) of factors
of production leads to economic growth – PPC shifts to the right
CONSEQUENCES OF ECONOMIC GROWTH

BENEFITS OF ECONOMIC GROWTH

• Greater availability of goods and services to satisfy consumer wants
and needs.
• Increased employment opportunities and incomes.
• In underdeveloped or developing economies, economic growth can
drastically improve living standards and bring people out of poverty.
• Increased sales, profits and business opportunities.
• Rising output and demand will encourage investment in capital
goods for further production, which will help achieve long run economic
growth.
• Low and stable inflation, if growth in output matches growth in
demand.
• Increased tax revenue for government that can be invested in public
goods and services, provision of healthcare, education and welfare
benefits for the poor.
• Increase in political and economic power – voting power at IMF is
influenced by GDP of an economy.
DRAWBACKS OF ECONOMIC GROWTH
• Environmental consequences — high rates of economic growth can
create negative externalities such as pollution, congestion, climate change
and land erosion. Such environmental impacts can damage people’s
wellbeing and quality of life in the long run.
• Risk of inflation — if the economy grows due to excessive demand,
there is the danger of demand-pull inflation. This leads to decline in the
country’s international competitiveness as exports become costlier.
• Rise in unemployment - Technical progress may cause capital to replace
labour, causing a rise in unemployment. This will be disastrous for highly
populated underdeveloped and developing economies, pulling more
people into poverty
• Resource depletion - scarce resources are used up rapidly when
production rises. Natural resources may get depleted over time.
• Inequalities in income - Economic growth has also been accused
of widening income inequalities in developing economies, because rich
investors and businessmen gain more than the working class and poor
during growth – the benefits of growth are not evenly distributed.
• Stress on workers – increase in output requires workers to work for
long hours

Governments aim for sustainable economic growth which refers to a rate of

growth which can be maintained without creating significant economic
problems for future generations, such as depletion of resources and a degraded
natural environment.

POLICIES TO PROMOTE ECONOMIC GROWTH

Economic growth can be promoted by using macroeconomic policies to
increase demand in the economy and boost the productive capacity of the
economy.
FISCAL POLICY
• cut in tax rates – increases consumer expenditure due to rise in disposable
income – leads to rise in output
• increase in government expenditure
MONETARY POLICY
Fall in interest rate – investment is cheaper – rise in capital investment –
increase in production
SUPPLY SIDE POLICY
Government spending on education and training to increase the productive
capacity of the economy
EFFECTIVENESS OF SUCH POLICIES
• Demand-side policies - cause inflation if maximum output is already
reached and there is no change in aggregate supply
• Supply-side policies can take considerable time to take effect. For
example, if the government invested in better education and training, it
could take several years for this to lead to higher labour productivity.
• In a recession, supply-side policies won’t solve the fundamental problem
of deficiency of aggregate demand. Increasing the flexibility of labour
markets and encouraging investment may help to some extent, but unless
there is sufficient demand, firms will be reluctant to increase production
and make new investments.