What can a government do to increase
economic growth? Discuss. [25]
Note:
This
essay has appeared before on my site; this is a second version.
What
can a government do to increase economic growth? There are many policies a
government can utilise to achieve this macroeconomic objective. Economic growth
can be measured by percentage increases in real Gross Domestic Product (GDP),
and there are two main aspects – actual and potential growth. Actual growth measures
the actual rate of change in the volume of output produced within a given
country, within a year. Potential growth is the percentage annual increase in
the economy’s potential capacity to produce output. Economic growth can be
increased via increasing aggregate demand (AD) and increasing aggregate supply
(AS), which target actual growth and potential growth respectively.
Thus,
this paper suggests that a government may introduce demand-management policies,
such as monetary and fiscal policy, which target actual growth, as well as
supply-side policies, which target potential growth, in order to increase
economic growth.
Demand-Management Policies
First,
a government can use expansionary demand-management policies. Monetary policy
is the manipulation of monetary variables such as money supply, interest rates,
and even the exchange rate (for example in Singapore’s case) to achieve macroeconomic
policy objectives such as steady, sustained economic growth, low and stable
inflation, a healthy Balance of Payments (BOP) and full employment.
Expansionary monetary policy may be employed to promote economic growth. It involves
reducing interest rates, where the reduction of interest rates leads to an
increase in consumption spending (C) or firms’ investments (I), thus raising AD,
or reducing the external value of the currency which makes a country’s exports
look relatively cheaper, thus boosting export sales. A reduction in interest
rates will increase consumer spending on consumer durables and may encourage
spending at the expense of savings. A lowered interest rate will also encourage
investment. As AD is made up of C + I + G + (X-M), (G means government spending
and (X-M) means net exports), hence, when both 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 AD to rise and thus,
promote actual growth.
In
terms of exchange rate policy, devaluation or depreciation in the exchange rate
is often used by governments of open economies that operate a fixed exchange
rate system or a managed float system. By devaluing their domestic currency, a
country would be more export competitive as their exports will appear to be
cheaper relative to other countries. 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 macroeconomic
objectives. To promote economic growth, to boost output and to increase employment,
a government can also employ an expansionary fiscal policy. The government can
increase government expenditure (G) or reduce taxes (t). 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 and employment, and thus promotes actual growth.
Supply-Side Policies
Secondly,
and on the other hand, 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 wages and prices 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 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 AS 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.
Limitations of Policies
However,
both aggregate 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 the consumer
and business outlook is gloomy, a fall in interest rates 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 the
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 cancel out the price advantages
resulting from a reduction in the external value of the currency.
Fiscal
policy may conflict with other macroeconomic goals because if AD increases by
too much, economic growth will be achieved at the cost of demand-pull 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.
Conclusions
Thus,
economic growth can 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 discussed and thus, a combination of policies
could result in better economic growth rather than the policies being utilised
as standalone measures to improve the economy.
JC Economics Essays – Tutor’s Commentary: This Economics essay on economic growth has appeared before
on my site; this is a second version (amended, revised, changed version). One
major problem with this Economics essay is that the conclusion is still not
evaluative enough. Economics tutors usually lament that their students cannot
write excellent evaluations after writing many excellent paragraphs before that.
How do you write an evaluative paragraph? One tip that many Economics tutors
give is that students should be sure to signpost their essays with phrases such
as: “to a large extent, in my opinion, it is likely that, one can argue that”,
and so on. Now put yourself back into the shoes of your own Economics lecturer
in school, here once again. How would a good Economics tutor make this conclusion
here better? Also, which diagrams do you need here, and why? A good Economics
tutor would point out that AD/AS would be really useful here: my advice for
this piece of work would be – always include a relevant Economics diagram and
also write an evaluative conclusion to get the highest, best grades.
