Factors to Determine Potential vs Economic Growth - Term Paper Example

Distinguish between potential and economic growth and discuss the main factors determining each. It is through the growth in economies that nations prosper: their people have better jobs, higher income, more access to goods and the overall standard of living improves. What is actually meant by the term ‘economic growth’? This paper will shed light upon the meaning of the term economic growth and how it comes about. The economic growth of a country can be described as the long term increase in the ability of the country to supply better economic goods, with more choices to its people. The question now arises that how does this capacity in effect increase? Also, is it important that this ability of supply is always realised? This paper will attempt to answer these questions. Take a look at an economy’s business cycle1 showing the potential and the actual growth. It can be seen that there are some discrepancies in the actual and the potential. Determinants of Potential Growth The Potential growth of an economy is the function of the supply side factors which determines the quantity of resources in the economy. Potential growth in the short term can be increased by a different set of factors, other than supply. But for the long run, aggregate supply needs to increase2. The Long Run Aggregate Supply curve can be shown as a vertical line in the graph. This figure depicts a yearly increase in the potential output of an economy, which consequently pushes the LRAS to over to the right also. It must be noted also that the progressive increase in Real GDP results in equitable increases in the rightward shift of the LRAS. So what causes the shift in the LRAS? These are described below: The labour force: The labour force can be described as all the people, 163 years of age and above, who are either employed somewhere, or are actively seeking employment (Labour force, 2005). Retirement age4 also affects the number of employable people in the market. The size of the labour force is not simply the size of the population. There are different factors that affect the size and quality of labour force. Population Demographics The birth rates and the death rates in a country play a major role in determining the size of available workforce, and also for making predictions for the future. For example, India, the second most populated nation of the world, has a steadily increasing birth rate, which predicts that the nation has and will have a surplus of available labour. Contrarily, most nations in Western Europe, for example Switzerland, have a decreasing birth rate, displaying the nation is likely to face a labour shortage. To match these, immigration5 plays a very important role. The chart displays the dependence that developed economies have on the developing world, esp. Asia, to fulfil their labour gaps. The reasons for immigration might be religious or political, but most importantly they are economic (Fairchild p145), where a person believes that he will be able to have a better chance of matching economic returns to the effort and labour he puts into his work and thus lead a better live with a higher standard of living. The Capital Stock in the economy: This is another very important resource. As opposed to the natural resources in the country, which as coal and oil, the capital stock needs development based on a) Investment spending (I) and b) Government spending (G). Both will be discussed later but it is important to note here that I can come from any source, including FDI, which assist in the development of capital stock. For G, the government allocates a budget for its priorities, e.g. education, overall country infrastructure, health, etc. The Quality of Resources: Here there are two aspects to consider. The resource can be natural such as oil, where a developing country is able to unearth that resource, and attracts foreign interest to purchase that resource from the country or even invest in the country to be able to extract that resource itself. This type of resource is nature-gifted and does not require much effort by the host company anyway. The other aspect is of course human invention which is manifested in technological advancement and acumen. This is also dependent upon I and G. When we speak of the quality of the capital stock, it is boosted by investment in R&D. One point here is that if the government allows tax breaks to companies which support R&D, this will result in an overall increase in the quality of the capital stock of the economy as more and more companies will be encouraged to pursue superior research and technological innovation. R&D is primarily conducted on private level, when funded by the government, so it is important to establish good collaborations between the two. The quality of the Labour Force: When we speak of quality, numbers and size do not matter but the value generated does. It is not sufficient to have a huge population of unskilled workforce. Adding quality is very important. This is done through education and health availability. Training though primary and secondary school, then vocational training and qualifications in schools, skills development, higher education in colleges and universities are all examples. The government must also provide financial assistance through loans, scholarships and grants to merit based students of all ages to develop their potential and make them valuable, quality workforce of the country. The quality found in the labour market is also influenced by the school retention rate (Other Factors Effecting Population Growth): “the proportion of students who, having started primary education, stay on to finish the post-compulsory years of their education”. All of these have an effect on the potential growth of the economy. Determinants of Actual Growth The actual growth rate is determined by Aggregate Demand, as opposed to the supply side. Let us take a look at what constitutes AD: AD: Ct + It + Gt + NXt Guell (2006) defines AD as: “The amounts of real domestic output that domestic consumers, businesses, governments, and foreign buyers collectively will desire to purchase at each possible price level.” Components C refers to consumption spending. This is part of AD or aggregate demand. This is all encompassing of things like expenditure on durable goods, services and non durable goods6. It is determined by the disposable income of households meaning the leftover income after all deductions including taxes. Furthermore, the wealth of the household, savings, plans for savings including insurance, confidence placed in the strength of the economy and the prevalent interest rate7 I refers to Investment Expenditure. This component proves to be the cause of the dynamism of the AD. It is inclusive of fixed investment in assets like plants, factories, equipment and machinery; it has a residential investment component which includes funding of new houses and complexes; also includes investment in business inventories8. Market confidence and business environment also affect Investment. Interest rates, overall monetary policy and the general situation of the financial and banking industry in an economy affect I. It is investment which determines the availability of newer capital stock in the market, which allows more goods and services in the market. G is referring to Government Spending. Taking a look at the chart9 below, it is easy to catch a glimpse of where the taxpayers’ money is being spent by the government. G is affected by the taxes collection and the state of the economy, meaning the priorities of the government set for spending. The final component is NX, which refers to Net exports. This means, exports less imports. Given this, it can be understood that the greater net exports means higher AD. At any given price level, if the foreign made good is cheaper than the local one, there will be an impetus to import; furthermore, the local good will be more expensive to the foreign buyer so export level will fall. The effect of such a policy of higher imports and lowers exports will be falling net exports (Cliffnotes.com). The net exports are determined by inflation, exchange rates, interest rates and GDP of nations involved. This will directly affect the AD, in turn affecting the actual growth of an economy. Relation Between Potential Growth and Actual Growth Output Gaps Now that we have an understanding of potential and actual growth, we can see them plotted on a graph10, it is impossible to have both matching each other all the time, however, they do intersect at certain output levels. These differences result in output gaps. Overutilization of resources will have an inflationary pressure, having a need for contractionary monetary policy. On the contrary, an expansive fiscal policy will encourage effective utilization of goods. Stagflation There can be a situation11 where the AS decreases, accompanied by rising inflation and falling employment levels. This is when the economy goes into stagflation. Forecasting Analysis of the potential growth can help in forecasting: as the forecast12 for the U.K. shows, that the actual GDP dipped in 2009-2010 period but should pick up by 2011. Conclusion The potential growth is determined by supply side factors such as resources, technology and capital stock. These need investment and government spending and incentives for development. The actual growth, however, is based on the aggregate demand of the economy which is a composition of various factors like spending and investment. Each component is influenced by many external factors and result in the actual output of the economy. Works Cited n.d., “Business Cycle”, http://www.algosys8.com/index.php/education/algosys_education/forex_rate Kuznets, S, 2004, “Modern Economic Growth”: Findings and Reflections, The American Economic Review, JSTOR Database, 63:3, 247-258 Labour force, 2005, Occupational Outlook Quarterly, http://www.bls.gov/opub/ooq/2005/winter/art05.pdf Henry Pratt Fairchild, HR, 2009, Immigration - A World Movement and Its American Significance, READ BOOKS, US n.d. “Other Factors Effecting Population Growth”, The Labour Force, Retrieved http://www.ecoteacher.asn.au/unemploy/a4.htm 2010, “Deficit Cutting Emergency”, The Market Oracle, http://www.marketoracle.co.uk/Article19922.html Guell, RC, 2006, Issues in Economics Today, McGraw-Hill/Irwin, NY CliffsNotes.com. Aggregate Demand (AD) Curve. 27 Apr 2011 . n.d. “The Components of Aggregate Demand”. Retrieved http://www.digitaleconomist.org/ad_4020.html n.d. “Monetary policy and inflation”. Monetary Policy Challenge. Reserve Bank of New Zealand. Retrieved http://www.rbnz.govt.nz/challenge/resources/2970552.html nd., “Aggregate Demand and Aggregate Supply”, Harper College, http://www.harpercollege.edu/mhealy/eco212i/lectures/ch10-17.htm Walayat, N, 2010, “UK Interest Rate Forecast 2010 and 2011”, fxstreet.comhttp://www.fxstreet.com/fundamental/analysis-reports/uk-interest-rate-forecast-2010-and-2011/2010/01/18/ Read More