Why are some countries rich while others are poor? The answer to this question explains the theory of economic growth. "The question so fascinated the classical economists that it was stamped on the front cover of Adam Smith's famous treatise, an inquiry into the nature and causes of the wealth of nations." Economic growth can be simply defined as the growth of real output of an economy over time. Economic growth is usually measured in terms of an increase in real gross national product (GNP) /gross domestic product (GDP) or as an increase in income per head, over time. The achievement of a high rate of economic growth is one of the four main objectives of macroeconomic policy.
Growth is desirable because it enables consumers to consume more goods and services, and thereby improving real living standards. It is important to distinguish between actual and potential growth. Actual growth is the percentage annual increase in national output. Potential growth, on the other hand, is the percentage annual increase in an economy's ability or capacity to produce. Actual growth is represented by a movement outwards of the production point on the production possibility curve which illustrates potential output. whereas potential growth is shown by a shift of the whole curve as illustrated below.
If potential growth exceeds actual growth, the difference is called spare capacity, which represents an opportunity cost to society as a whole in terms of lost resources. Actual growth may only exceed potential growth in the short run as long run actual growth is restricted to the rate of potential growth. Short run economic growth can come about through a fuller use of resources but for it to be sustained there must be an increase in potential output. Short run policy issues are aimed towards keeping actual growth as close to potential growth as possible, whereas long run policy issues are aimed at finding out what determines potential growth. The main factor affecting the rate of growth of actual output is the level of aggregate demand. Aggregate demand is the sum of consumption (C) plus investment (I) plus government expenditure (G) plus the balance of payments (exports (X) minus imports (M) ).
A fall in aggregate demand creates more excess supply in order to sell excess stock, this fall in price increases demand as consumers aim to maximise the purchasing power of their disposable income. Short run variations in aggregate demand causes fluctuations in actual growth along with the business or trade cycle. The trade cycle can be simplified to four stages. The upturn is whereby a contracting or static economy begins to recover.
Expansion is the third stage whereby a fuller use of resources is made and economic growth is a t its maximum. The gap between actual and potential output narrows at this stage. The third stage is called peaking out whereby growth slows or even stops. The final stage is called the slowdown or recession as at this stage growth slows, stops or declines as the volume of spare capacity increases. A diagram of the trade cycle is shown below. The dotted line represents the average or trend rate of actual growth.
A rapid rise in aggregate demand however, is not enough to ensure high levels of growth in the long run. There are two main determinants of potential growth in the long run and they are concerned with the quantity and quality of the factors of production (land, labour and capital). "Factors of change internal to the economic system are changes in tastes, changes in quantity (or quality) of factors of production, changes in methods of supplying commodities" (Sumpter 1939, 73) Increases in the stock of capital goods will generate an increase in output, by how much output is raised is dependent upon the marginal efficiency of that capital. An increase in the amount of labour available or an increase in the working population will increase potential output.
Growth due to an increase in the amount of land and raw materials available is normally limited as land is virtually fixed in quantity and even if new resources are developed growth will only be affected in the short run. If a single factor of production increases in supply while others remain fixed, diminishing returns will set in unless all of the factors of production increase in quantity, therefore the rate of growth is likely to slow. The solution to this problem is the productivity of resources. As I have already stated, potential growth is determined by the quantity of resources available, an increase in the quantity of the factors of production can be defined as a factor that shifts the long run aggregate supply curve to the right, reflecting an increase in the ability and willingness of firms to produce at each and every given price level over a given period of time. The diagram below illustrates this shift. Many economists believe that the diagram above also shows economic growth as it represents an increase in the 'potential' of an economy or country to produce goods and services.
Potential growth is also brought about through increases in the quality or productivity of resources. Technological progress has tended to increase the productivity of capital over time. A more skilled labour force through education, and training will increase labour productivity over time. Potential growth is dependant upon factor productivity. Certain "theories helped to clarify the role of the accumulation of physical capital and emphasized the importance of technological progress as the ultimate driving force behind sustained economic growth." Although the main determinant of long-term growth is the rate of technological advance, innovation must also be encourages in order to sustain that growth over time. Investment is also a determinant of potential output as it increases capital stock and encourages the development of new technology.
Some economists argue that an alteration in actual growth stimulates investment, which encourages potential growth in the long run. Governments can act to increase economic growth through the use of demand side or fiscal, policy for example, by decreasing taxation levels and increasing government expenditure which will generate actual growth in the short run through increasing aggregate demand. Government expenditure on education and healthcare can encourage potential growth in the long run. Monetary policy through reducing interest rates decreases the cost of borrowing which in turn reduced the opportunity cost of expenditure therefore increasing actual growth. In conclusion, economic growth or growth of real output in an economy brings advantages through increased wealth and higher living standards, whilst it can also bring disadvantages such as the exhaustion of finite natural resources.
However many others and I believe that the benefits of growth outweigh the costs. Although actual growth is desirable it is increase in potential or long run growth that is one of the real aims of macroeconomic policy. Long run growth is brought about through an increase in the availability and productivity of the factors of production. Investment also is key to achieving both actual and potential growth as it affects aggregate demand and supply in both the long and the short run.