Economic growth and the economic cycle

The level of national income is an important influence on a country's standard of living although, as we saw in the previous unit, it is not the only determinant of this. Increasing national income and achieving economic growth is a common economic objective.

Economic growth can be measured by an increase in the real output or income of an economy over time. This may be measured in terms of the whole economy or in terms of output or income per person.

Economic growth creates more income in the economy. This can lead to a higher aver­age income per person (although the income may not actually be distributed equally). This is often linked to a higher standard of living. Greater earnings can contribute to greater welfare and a more content nation.

Remember, however, that a fast rate of growth is often achieved by economies that are industrialising quickly and starting from a relatively low base. India, for example, has grown rapidly in the last twenty years, but the average income per head was still less than $1000 per year by 2006. More mature economies may have higher incomes per person but slower economic growth.

When examining economic growth, it is sometimes helpful to distinguish between actual and potential growth.

· Actual growth is the rate at which the economy is actually growing. It is measured by the annual percentage increase in national income.

· Potential growth measures how much the economy could grow with al! of its resources fully employed; i.e. it represents an increase in the capacity of the economy.

The difference between the two can be seen using production possibility frontiers. The movement from X to Y represents actual growth in the economy because more is pro­duced; in this case resources are being used more fully rather than an increase in capacity. Actual growth may be caused by a boost in aggregate demand. Potential growth is shown by an outward shift of the production possibility frontier. This represents potential growth because the economy is increasing what it can produce whilst still utilising all of its resources fully. Potential growth may be caused by:

· an increase in resources, such as a population increase;

· improvements in technology or the way resources are used (e.g. better management.

I. Restore the word order in the questions and answer them:

1) What an important influence on a country's standard of living is?

2) What a common economic objective is?

3) How economic growth can be measured?

4) Economic growth is often linked to a higher standard of living?

5) India has grown rapidly in the last twenty years?

II. Complete the following statements:

1) Actual growth is….

2) Potential growth is….

3) Actual growth may be caused by….

4) Potential growth may be caused by….

2) Translate the text “What causes inflation?”.

The causes of inflation include the following.

● Too much demand in economy. This is shown by an outward shift of the aggregate demand curve. If demand is growing faster than supply then this will pull prices up, causing ´demand-pull inflation'. If firms cannot meet the demand then they will increase their prices. Demand-pull inflation is characterized by shortages, low levels of stocks, long waiting lists and queues. In this situation firms will be eager to produce more as soon as they can. They may invest in extra capacity, but this can take time to come online. In the short term supply is likely to be price inelastic because firms may not be able to recruit staff easily or produce more given the existing equipment. This means that an increase in demand will affect prices more than output. Inflation caused by an increase in demand is shown in Table 5.

● Cost-push inflation. This type of inflation is caused by costs increasing; for example, higher wages that are not related to productivity gains, higher import prices or monopoly suppliers pushing up their prices. Faced with higher costs, firms increase their prices to customers to maintain profit margins. This shifts the aggregate supply curve to the left and causes cost-push inflation (see Fig. 29.2). An inward shift of the aggregate supply will also lead to a fall in output and to firms operating under capacity.

● Monetary inflation. According to monetarists, inflation occurs when there is too much money supply in the economy. With money circulating this leads to more demand in the economy and then higher prices. This is a form of demand-pull inflation that is caused specifically by excess growth of the money supply.

To control inflation there are a variety of methods that the government may use, such as the following.

• Reducing the aggregate demand. To control demand-pull inflation the government will want to reduce the level of the aggregate demand in the economy relative to supply. This may be done using deflationary fiscal or restrictive monetary policies.

• Reducing costs. To control cost-push inflation governments may do the following.

• Governments may introduce wage controls to prevent wages from increasing too fast. This is known as an incomes policy. However, incomes policies can lead to frustration on the part of employers, who want to offer more money to reward and attract good quality employees. Employees may also be frustrated and look for^: better-paid jobs abroad.

• Governments may try to influence the exchange rate to make the external value of' the pound stronger. This gives UK-based firms more purchasing power, making it cheaper to buy in supplies from abroad. However, it may affect exports adversely.

• Setting inflation targets. By setting clear targets for inflation and giving the relevant organizations the authority to take actions to achieve these, a government can try to con­vince households and business people that such targets will be met. For example, the UK government in 2004 onwards had an inflation target of 2%. Its success in achieving this target early on helped to convince individuals and groups that this was going to be the level of inflation in the future. As a result, wage claims and price increases were-linked to this level of expectations. If, on the other hand, people think that inflation is going to be very high then they will demand high wages. This could cause higher prices due to cost-push inflation. This inflation could then stimulate higher wages, higher costs and higher inflation again. This is called the 'wage-price spiral'.

Inflation can cause a number of problems for an economy, such as the following:

• If prices are increasing this creates costs for firms because they may update their promotional material to reflect the higher prices. For example, this means reprinting brochures, updating price lists and changing vending machines. These are called “menu costs”.

• With higher rates of inflation, individuals and firms may have to search more to find the best returns on their savings. This will be necessary to preserve the real rate of return (i.e. the return adjusted for inflation). The costs of searching around are called “shoe leather costs”.

• Not all individuals will have the bargaining power to ensure that their own earnings rise at the same rate as prices are increasing. If your wages do not increase as much as prices then, in real terms, you are worse off. Your real income has fallen. The ability of an employee to bargain for higher wages in line with inflation depends on the extent to which they are in demand and/or whether they are well represented by trade unions. Inflation may therefore redistribute real incomes. Some groups may find that their earnings keep pace with inflation, others may not. This means that inflation has redistributive effects.

• Internationally, if the prices of firms in the UK are increasing faster than their trading partners then this may make the country’s products uncompetitive compared to those of foreign firms. This may reduce the earnings from exports and increase the spending on imports. This will affect the balance of payments adversely. Domestically, the UK may also struggle to compete because imports will be relatively cheaper.

• Inflation may also damage business confidence because of fears about the future impact on costs. This may reduce levels of investment.

• Tax thresholds often do not increase in line with inflation. If employees gain a pay increase to match inflation then they are not better off in real terms. However, with j higher nominal pay individuals may enter a higher tax band and therefore be worse off. This is called fiscal drag. Again, inflation is redistributing income.

The effects of inflation will depend partly on whether it is 'anticipated' or 'unanticipated' inflation. If you know that prices arc going to rise and you have the bargaining power then you can demand higher wages to compensate, for example. However, if you are locked into a 2% pay increase and then inflation unexpectedly increases to 5% then you will be worse off in real terms. If inflation levels are regularly unanticipated then this will lead to high levels of uncertainty in the economy, which may deter investment and affect spending and saving decisions. The impact also depends on the levels of inflation; high levels are more damaging than low levels.

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