Economic Growth - Some Core Concepts

This study note looks at some core concepts relating to economic growth.

What’s the difference between:

Actual economic growth and potential economic growth

Actual economic growth is measured by the annual percentage change in a country’s real national output (GDP).

Potential economic growth is also known as trend growth and is measured by the estimated annual change in a country’s potential level of national output. Potential growth is driven by improvements in long run aggregate supply (LRAS).

Nominal economic growth and real economic growth

Nominal economic growth is the annual rate of change of the money value of GDP expressed at current prices.

Real economic growth adjusts nominal economic growth to take account of changes in consumer prices. This is done using a measure of inflation such as the GDP deflator which is a broad measure of cost inflation.

Real GDP (2019) = Nominal GDP (2019) x 100 / GDP deflator for 2019

If nominal GDP is rising less quickly than prices, then real GDP will fall (contract) - this is a sign of a country falling into recession

Growth fuelled by consumer spending

In most countries, consumer spending on goods and services is the biggest single component of Aggregate Demand (remember that AD=C+I+G+X-M). In the short run, a rapid growth of consumer spending can be a major factor causing a cyclical expansion in demand, production and jobs.

Advantages of growth fuelled by consumer spending:

1. Fast growth of consumer spending allows for an increase in living standards as people are able to purchase more goods and services
2. Increased consumer spending will lead to higher revenues for firms and greater profits. This might then lead to a rise in planned capital investment spending as suppliers look to increase the size of their capital stock to expand their productive capacity. A good example is increased consumer spending on broadband services which is prompting a rise in investment in the broadband network.

Disadvantages of growth fuelled by consumer spending:

1. High levels of consumer spending might be financed by debt and this borrowing (and the resulting decrease in household saving) can become a major problem when interest rates start to rise and the rate of GDP growth slows down. Recessions have been caused in the past when a consumer boom comes to an end and households find their finances are squeezed by the problems of paying the interest on and trying to run down the level of debt.
2. Higher consumption can lead to a worsening of a nation’s trade deficit especially when households have a high income elasticity of demand for imported goods and services. Unless there is a compensating rise in export sales or net inflows of primary and secondary income, then the current account deficit will grow during a consumer boom.

Export-led growth

Export led growth is where a significant part of the expansion of real GDP, jobs and per capita incomes flows from the successful exporting of goods and services from one country to another. In recent years a number of countries have experienced rapid export growth which has helped to fuel their long-run expansion. These nations include China, Ireland, South Korea, Singapore, Hong Kong, Vietnam, Ethiopia, Kenya and other emerging countries.

Advantages of export-led growth:

1. Exports of goods and services are an injection into the circular flow of income leading to a rise in aggregate demand and an expansion of output. This helps to raise per capita incomes and reduce extreme poverty. Growing export sales provide revenues and profits for businesses which can then feed through to an increase in capital investment spending through the accelerator effect. Higher investment increases a country’s productive capacity which then increases the potential for exports.
2. Many industries help facilitate trade such as trade insurance, logistics and port facilities. Countries with fast-growing export sectors are likely to see increased investment and employment in these industries. A good example is the importance of trade to countries such as the Netherlands (including the port of Rotterdam), and Singapore and Hong Kong both of which have developed globally-scaled hubs for trade

Drawbacks from export-led growth:

1. Focusing on exporting might lead to over-dependence on the economic cycles of trade partner countries and vulnerability to external economic and political shocks
2. Running persistent trade surpluses might incite a protectionist response from other nations who feel that the benefits of trade have been unequally skewed in favour of exporting countries. Huge trade imbalances remain a big concern in the global economic system
3. Rapid export-led growth might lead to demand pull inflation and therefore higher interest rates. High relative inflation might then have the effect of making export industries less competitive in overseas markets and domestic producers less price competitive against imports
4. Export-led growth might be unsustainable if it contributes extraction of natural resources beyond what is required for long term balanced growth to be maintained. Consider the impact of deforestation and over-fishing and degradation of land by industrial-scale farming

Quizlet Revision Test on Economic Growth Concepts

Summary of key terms

Capital stock

The value of the total stock of inputs such as plant and machinery, technology and buildings.

Economic growth

Long run increase in a country's productive potential

External shocks

Unpredictable events such as volatile prices for oil, gas and foodstuffs

Foreign direct investment

Inflows of capital from foreign multinationals including takeovers and investment in new factories.

Human capital

A measure of individuals' skills, knowledge, abilities, social and health attributes

Hysteresis

When a sustained period of low aggregate demand and high unemployment can lead to permanent damage to aggregate supply

Infrastructure

Transport links, communications networks, sewage systems, energy plants and other facilities essential for the efficient functioning of a country

Net inward migration

When the number of people coming into a country is greater than those leaving in a given time period

Output gap

Difference between actual and potential national output

Productivity

How much output is produced for a given input (such as an hour of work)

Research and development

Creation and improvement of products and processes, based on scientific research - applied to market needs.

Stagflation

A combination of slowing economic growth and rising inflation

Sustainable growth

Growth that meets the needs of the present without compromising the ability of future generations to meet their own needs

Inclusive growth

Growth where the benefits are spread across all sections of society - i.e. shared growth, and pro-poor growth

Accelerator effect

Where planned capital investment is linked positively to the past and expected growth of consumer demand

Brain drain

Movement of highly skilled people from their own country to another country where they can earn more money

Catch-up effect

Occurs when countries that start off poor tend to grow more rapidly than countries that start off rich

Knowledge capital

Scientific and technological know-how that raises productivity

Creative destruction

Dynamic effects of innovation in markets where new products or business models lead to a reallocation of resources

Innovation

Making changes to something established and creating new intellectual assets