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What can a government do to increase economic growth? Discuss. [25] (Second Version, Revised)

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.


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. 

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