(b) What can the government do to increase Economic Growth? [15]
There are many policies a government could undertake to increase economic growth. Economic growth is measured by percentage increase in real Gross Domestic Product (GDP). There are two main aspects to economic growth. Actual and potential growth. Actual growth (AG) measures the rate of change in the volume of output produced within the country in a year. Potential growth (PG) is the percentage annual increase in the economy’s capacity to produce. Economic growth can be increased via increasing aggregate demand and increasing aggregate supply. Thus, the government may introduce demand management policies, such as monetary and fiscal policy as well as supply-side policies in order to aid economic growth.
Monetary policy is the manipulation of monetary variables such as money supply, interest rate and the exchange rate to achieve macroeconomic policy objectives such as steady and sustained economic growth, low and stable inflation, a healthy Balance of Payment (BOP) and full employment. Expansionary Monetary Policy may be employed to promote economic growth. It involves, raising monetary supply, reducing interest rates (as seen from Figure 1 - think of WHAT diagram and HOW to draw the diagram) where the reduction of interest rates leads to an increased supply of goods or reducing the external value of the currency. A reduction in interest rates will increase consumer spending on consumer durables. It may also encourage spending at the expense of saving. It also increases the amount available to spend after people have paid less for loans with low interest rates. A lowered interest rate will also encourage investment. This is shown in Figure 2 as AD0 increases to AD1 as AD is made up of C + I + G + (X-M). Hence, when C and I increase, AD shifts to the right. A lower cost of borrowing will increase the incentive for investment as now the returns would be greater. The increase in both consumption expenditure (C) and investment expenditure (I) will cause the AD to rise and thus, promote actual growth. A reduction in exchange rate is often used by governments of open economies that operate a fixed exchange rate system. By depreciating their domestic currency, a country would be more export competitive as their exports to other countries will be cheaper. Assuming the Marshall-Lerner condition is satisfied, net exports as well as AD will rise. This, in turn, will cause output and employment to increase.
Fiscal policy refers to the use of government spending and taxation to achieve the macroeconomic objectives. To promote economic growth, boost output and employment, a government can also employ an expansionary fiscal policy. With reference to Figure 3, the economy initially operates at A which is below the full employment level Yf. The government could adopt an expansionary fiscal policy. The government can increase government expenditure (G) or reduce taxes. An increase in G will cause an increase in aggregate demand directly since AD = C + I + G + (X-M). A reduction in personal income tax would raise consumption as it would further increase the disposable income of households and thus their ability to spend. Moreover, a decrease in corporate tax will increase profits and hence raise the level of investment in the economy. An expansionary fiscal policy thus raises AD and hence, output, employment and thus promotes actual growth.
To promote potential growth, the government may adopt supply-side policies. Supply-side policies are designed to shift the AS curve to the right by increasing the quantity and quality of resources via improving the efficiency in product and labour markets, and also by improving the level of technology. A reduction in labour market rigidities can be carried out via provision of education and training, reduction in direct taxes, cut in unemployment benefits, reforming trade unions and wage and price policies. Education and training can raise labour productivity and mobility and thus increase productive potential of the country. Labour productivity or the efficiency of labour is measured by output per hour worked. Reducing personal income tax and corporate tax rates can raise the productive capacity of a country by increasing the quantity and quality of labour and capital available to a country. A lower income tax rate would create incentive for work as now there is as expansion in the amount of disposable income. A lower corporate tax rate would also increase investment as the businessmen would be able to keep a larger share of profits. The cut in unemployment benefits will also increase the incentive to work as the unemployed would be disadvantaged if they are not engaged in productive labour. The power of trade unions can also be reduced by the government as this would result in a reduction of wages of labour. This, in turn, will increase employment, labour markets flexibility and efficiency. Thus, if labour costs to employers are reduced, their profits will probably rise. This would encourage and enable more investment and economic growth.
Pro-business policies are designed to promote greater private investments in the country. These include building world-class infrastructure, investing in R&D and tax reforms to ensure greater compatibility with international trends in taxes. The government can also increase Aggregate Supply via the adoption of more pro-competitive policies such as the passing of anti-monopoly laws, removal of barriers to entry to certain regulated industries, eliminating tariffs as well as other restrictions on imports.
However, both demand and supply side policies have their share of limitations. Reducing interest rates may cause the country’s currency to depreciate as it encourages hot money outflows. A lower exchange rate will make the exports of a country more competitive whereas imports will be dearer. Moreover, if consumer and business outlook is gloomy, a fall in interest rate may not encourage firms and households to increase borrowing because firms’ profits are falling and consumers may be expecting lower wages and lower year-end bonuses. When exchange rate is reduced, if the economy is operating near or at full employment, inflation will result. If the demand for exports and imports is price inelastic, net exports and AD will fall. This, in turn, will cause output and employment to fall. Hence, inflation can annul the price advantage resulting from a reduction in the external value of the currency. Fiscal policy may conflict with other macroeconomic goals as if AD increases by too much; economic growth will be achieved at the cost of inflation. Also, if the government has to borrow in order to increase spending, it may result in a BOP deficit. The decrease in tax rates may not bring about the desired increase in consumption and investment if households and businesses are pessimistic about future prospects. Moreover, a cut in personal income tax may induce an increase in the amount that they save rather than spend. The full effects of an expansionary fiscal policy may only be felt after a considerable time period. Thus, its effectiveness may not be realised in the short term. Supply-side policies such as education and training take time to have an effect and are also very costly. Reducing taxes may encourage some people to work fewer hours so that they can enjoy more leisure. Reducing corporate taxes may result in firms paying higher dividends rather than undertaking more investment. Cutting unemployment benefits would also not guarantee that it would reduce unemployment as jobs are not created and neither are their skills upgraded. It increases the urgency of finding a job. However, it does not increase their capability of getting a job.
Thus, economic growth ca be achieved via Fiscal Policy, Monetary Policy, Supply-side policies as well as by pro-business policies. However, it may be achieved at the expense of the limitations named above and thus, a combination of the policies could result in better economic growth rather than them being utilised as a stand alone measures to improve the economy.
JC Economics Essays: Tutor's Comments: A very well written essay, which was composed under examination conditions. Total Marks: 20.5/25.
Further Economics tutor's comments: think of how you could work on this Economics paper to make it better, tighter, clearer, or worth more marks. Also, think of how the conclusion could be made more evaluative, interesting, and readable. Do think of how to draw the relevant and proper Economics diagrams for this essay as well. Thanks for reading and cheers!
Further Economics tutor's comments: think of how you could work on this Economics paper to make it better, tighter, clearer, or worth more marks. Also, think of how the conclusion could be made more evaluative, interesting, and readable. Do think of how to draw the relevant and proper Economics diagrams for this essay as well. Thanks for reading and cheers!
