Development Economics - Consequences of economic growth and the balance between markets and intervention
Terms in this set (42)
Overall impact on economic growth
Economic growth impacts upon many aspects of the economy, and some of its possible consequences are positive while others may be negative. It is important to note that many of these consequences, whether positive or negative, are not inevitable, but rather follow from the ways that growth is pursued.
Economic growth and the impact on living standards
If the total GDP of a country increases faster than its population, then an increase in GDP per capita results.This indicates that there is a greater potential for people to increase their consumption of goods and services, and improve their standards of living.
However, remember that GDP per capita or income per capita is only an average measure, and does not tell us how the increase in income is distributed or whether there is a broadly distributed improvement in living standards. More appropriate measures of living standards are provided by the Human Development Index as well as other indicators of development, such as infant mortality or maternal mortality. The interesting question therefore is whether economic growth leads to human and economic development, measured as improvements in a country's HDI or other development indicators.
According to studies making cross-country comparisons, economic growth is associated with improvements in indicators measuring economic and human development.1 This is what we would expect, since growth provides additional resources allowing for improvements in standards of living. However, improvements in development indicators are highly variable, so that for a given rate of growth they are in some cases small and in others much larger.
What accounts for differences in the contributions made by economic growth to standard of living improvements? - summary
According to an important study of this topic for developing countries, major factors allowing economic growth to have positive effects on economic and human development include the following:
1. The distribution of income
2. Household spending on items that promote human development
3. The share of income controlled by women
4. Government spending on items that promote human development
5. Contributions by non-governmental organisations (NGOs)
6. Effectiveness of spending to promote human development
What accounts for differences in the contributions made by economic growth to standard of living improvements? - The distribution of income
The greater the income going to poorer households, the greater the potential for contributing to human development, as the poorer households are those with the greatest deprivations in terms of education and health. If increases in income made possible by economic growth bypass the poorer households, growth has limited effects on human development.
What accounts for differences in the contributions made by economic growth to standard of living improvements? - Household spending on items that promote human development
The greater the share of household income spent on goods and services such as food, education and health care, the greater the effect on human development.
What accounts for differences in the contributions made by economic growth to standard of living improvements? - The share of income controlled by women
The greater this is, the stronger the impact on human development.
What accounts for differences in the contributions made by economic growth to standard of living improvements? - Government spending on items that promote human development
This relates to the share of the government budget allocated to priority areas like education, health care and infrastructure including clean water supplies and sanitation; the larger this is, the greater the effects of growth on human development.
What accounts for differences in the contributions made by economic growth to standard of living improvements? - Contributions by non-governmental organisations (NGOs)
Because of their poverty orientation and their general effectiveness in reaching poor people, NGOs contribute
to increasing the impact of growth on more development and higher standards of living.
What accounts for differences in the contributions made by economic growth to standard of living improvements? - Effectiveness of spending to promote human development
Depending on their level of development, different countries have different needs, which determine the effectiveness of spending to achieve human development. For example, very poor countries need to invest more in primary education to achieve universal literacy, rather than in secondary or tertiary education. Some countries may need to invest more in safe drinking water or sanitation rather than in health care services in order to have a greater impact on health. The greater the effectiveness of spending, the greater the impacts on human development.
OVERALL impact of economic growth on living standards
Therefore, while economic growth offers the potential to achieve improvements in human development and standards of living, these improvements do not occur automatically as a result of economic growth but require appropriate policies to make effective use of the resources growth makes available.
Economic growth and unemployment - OVERALL
To understand the effects of economic growth
on unemployment, we must make a distinction between different types of unemployment, the key distinction being between cyclical and natural (of which structural is the most important). In addition, it is useful to make a distinction between economic growth occurring in the expansionary phase of the business cycle, and long-term economic growth shown by increases in potential output.
1. economic growth due to the short-term fluctuations of the business cycle can mainly reduce (and possibly eliminate) cyclical unemployment,but with only a temporary impact on natural unemployment
2. Sustained (not temporary) reductions in natural, and particularly structural, unemployment may result from long-term economic growth, involving increases in potential output, shown by rightward shifts in the LRAS or Keynesian AS curves
3. In certain situations, economic growth may itself lead to increases in structural unemployment
4. Economic policies pursued by government can
also work both ways, either increasing or reducing unemployment over the longer term
Economic growth and cyclical unemployment
Economic growth due to the expansionary phase of the business cycle affects cyclical unemployment, which as we know falls in an expansion (and increases in a contraction). If aggregate demand continues to increase beyond the full employment level of real GDP, leading to an inflationary gap, unemployment falls below the natural rate. However, this will only be temporary as government authorities are likely to step in with contractionary policies intended to close the inflationary gap and bring real GDP back toward its potential level with unemployment returning to the natural rate.
Therefore, economic growth due to the short-term fluctuations of the business cycle can mainly reduce (and possibly eliminate) cyclical unemployment,
but with only a temporary impact on natural unemployment.
Long term economic growth and the natural rate of unemployemnt
Sustained (not temporary) reductions in natural, and particularly structural, unemployment may result from long-term economic growth, involving increases in potential output, shown by rightward shifts in the LRAS or Keynesian AS curves. Increases in potential output are caused by supply-side factors, such as increases in resource quantities, improvements in resource quality, technological change, etc. However, not all increases in potential output lower natural unemployment. Depending on the particular factors that cause potential output to increase, natural and therefore structural unemployment may increase, decrease, or remain the same.
Economic growth and structural unemployment
In certain situations, economic growth may itself lead to increases in structural unemployment (a part of natural unemployment). This could occur when growth results from technological changes leading to a fall in the demand for certain labour skills. In developing countries, growth could result from the introduction of inappropriate technologies (such as capital intensive technologies), which would cause unemployment to rise.
Government policies and unemployment
Economic policies pursued by government can
also work both ways, either increasing or reducing unemployment over the longer term. This topic was discussed in supply/demand side policies, where our analysis of the effects of supply-side policies on unemployment showed that market-based policies based on labour market reforms, and certain interventionist policies including investments in human capital, can work
to reduce the natural rate of unemployment. Other market-based policies, however, such as privatisation, and trade and market liberalisation, may work to increase it.
OVERALL impact of economic growth of unemployment
It follows then, that long-term reductions in unemployment require economic growth, but not all economic growth results in lower unemployment. While economic growth offers the potential to reduce unemployment, whether or not this will occur depends on the particular factors and policies that lead to growth.
Economic growth and inflation
As in the case of unemployment, it is useful to make a distinction between economic growth due to the expansionary phase of the business cycle, and long- term economic growth or increases in potential output. In addition, the effects of growth on inflation depend partly on whether we use a monetarist/new classical or Keynesian approach.
The dissagreement between models over inflation
In the expansionary phase of the business cycle, as real GDP increases due to increases in aggregate demand, the price level remains constant in the Keynesian model because of spare capacity and the presence of unemployed resources in the economy; this involves real GDP increases along the horizontal part of the AS curve. However, as real GDP approaches the level of potential output, resource bottlenecks begin to cause increases in resource and product prices, and continued aggregate demand increases beyond the level of potential output become highly inflationary.
In the new classical/monetarist model, an increase in aggregate demand always causes an increase in the price level, even if the economy is initially in recession; in the long run an increase in AD leads only to price level increases.
Therefore, while there is disagreement between the two models on what happens to the price level in a recession, there is agreement between them that growth caused by increases in aggregate demand at about or beyond the level of potential output is inflationary.
The agreement between models over inflation
In addition, there is agreement between the two models that long-term economic growth, involving increases in potential output, work to reduce inflationary pressures. This can be seen clearly in Figure 9.15 (page 256), where increases in aggregate demand are matched by increases in the LRAS and AS curves respectively. With increases in the productive capacity of the economy due to economic growth, growth in aggregate demand can be easily met without causing upward pressures on the price level.
Economic growth and the distribution of income
A large number of studies have been carried out investigating the relationship between growth in
GDP per capita and income distribution in developing and developed countries. The results have been inconclusive: while in some countries income distribution worsened in the early periods of growth and then improved, in some others the opposite happened, while in many others, income distribution did not show any clear pattern of change. These results lead to the conclusion that there is no clear relationship between growth in GDP per capita and income distribution; instead, what happens to income distribution as a country grows is a reflection of particular conditions in each country and the kinds of growth policies that are pursued.
Factors behind increasing inequality with income distribution
In both developed and developing countries, a major factor behind increasing income inequalities has been the growing use of market-based supply- side policies. Transition economies have additionally been influenced by the switch to market economies and the loss of government protection of vulnerable groups. In developing countries, income inequalities increased due to economic and trade liberalisation, which we have seen gives rise to both winners and losers. While those who can take advantage of new opportunities gain, many become worse off, if they are less educated or skilled, cannot get credit, are geographically isolated, have nothing to produce for export, lose their jobs due to privatisations or reductions in the size of the government sector,
and so on.
How income distribution can worsen with economic growth
In addition, income distribution in developing countries can worsen as a result of economic growth due to inappropriate government policies, such as:
1. the introduction of capital-using (labour-saving) technologies in industry and agriculture, creating rural and urban unemployment
2. low levels of government investment in human capital, which negatively affect people on lower incomes and the poor disproportionately more than wealthier people
3. allocating most services and infrastructure investments to urban areas and ignoring the rural sector where most of the poor live
4. within the urban sector, concentrating infrastructure and services investments within the formal (modern and highly paid) sector and ignoring the urban slums.
OVERALL impact of economic growth on income distribution
It can therefore be concluded that economic growth is neither 'good' nor 'bad' for income distribution; this instead depends very much on the kinds of policies countries adopt in order to achieve growth.
Short term economic growth and the current account
Short-term economic growth, occurring over the business cycle, may lead to a larger current account deficit (or a smaller current account surplus). The reason is that increasing incomes lead to an increase in the demand for imports, and therefore a worsening balance of trade (the most important part of the current account balance). This is especially the case if consumers' marginal propensity to import is high, indicating that a large fraction of an increase in incomes leaks out of the spending flow to purchase imports; or when the demand for imports is income elastic, indicating that a given percentage increase in income will lead to
a proportionately larger increase in the quantity of imports demanded.
Long term economic growth and the current account - summary
However, when a country experiences long-term economic growth, the trade balance (and the current account balance) are determined by factors that are likely to be unrelated to the rate of economic growth, such as the following:
1. The international competitiveness of domestic industries
2. Exchange rates
3. The degree of export orientation of the economy
4. Growth of incomes of trading partners
5. The degree of protectionist trade policies faced by exports
Long term economic growth and the current account - The international competitiveness of domestic industries
If domestic industries are efficient, low-cost producers, they may have a competitive advantage over other countries, resulting in higher levels of exports, and therefore a smaller trade deficit (or larger trade surplus) even as the economy grows.
Long term economic growth and the current account - Exchange rates
If the country's exchange rate is weak or undervalued (relative to its market value) it creates an artificial competitive advantage, resulting in more exports and fewer imports, working to reduce the size of a trade deficit, even as the economy may be growing.
Long term economic growth and the current account - The degree of export orientation of the economy
Economic growth that depends heavily on increases in exports may result in strong trade surpluses even as incomes increase. A good example is China, which has been achieving high rates of growth together with large trade surpluses.
Long term economic growth and the current account - Growth of incomes of trading partners
If incomes abroad are growing rapidly and for extended periods, there will likely result increases in exports, even as the country itself is growing.
Long term economic growth and the current account - The degree of protectionist trade policies faced by exports
If a country's exports do not face trade barriers in other countries, it may be able to increase its exports (assuming it is an efficient producer) even as its economy grows.
OVERALL impact of economic growth on the current account
Therefore, in examining the relationship between economic growth and the current account balance of a country, we may find economic growth leading to a larger deficit or smaller surplus in the upward phase of the business cycle, while over the longer term we are likely to find that there is no clear relationship: as the economy grows, the current account balance may improve, stay the same or worsen, depending on what happens to the factors listed above.
Economic growth and sustainability
Experience shows that growth, especially rapid growth, often leads to unsustainable resource use (particularly in the case of common access resources).
For example, very high growth rates in East Asian countries have been associated with serious environmental losses taking the form of very high levels of urban air pollution, threats to biodiversity, and serious deforestation.
Industrialisation based on fossil fuels is a major source of pollution (negative production externalities). Increasing incomes lead to consumption patterns also based on greater fossil fuel consumption (use of cars, air conditioners, etc., creating negative consumption externalities).
This has lead to the current thinking by governments 'grow now, clean up later' way of thinking, which argues that since using resources to preserve the environment reduces growth, it is preferable to pursue growth with all its negative effects on the environment, and postpone the 'clean-up' job of environmental preservation for later when incomes will be higher. This way of thinking is followed not only by rapidly growing economies, but also slow-growth economies, because the evidence shows that even countries that do not experience rapid growth also suffer major environmental losses.
The dangers of the 'grow now, clean up later' attitude
One is that some environmental damage is irreversible; it will not be possible to correct the damage in the future, and some resources will be lost forever. For example lost lives due to pollution-induced illnesses can similarly never
A second is that it justifies government inaction on the environment. Governments and policy- makers often wrongly assume that environmental issues will automatically be regained in the future as incomes increase with growth. This is unrealistic, because preservation of the environment requires policies aiming to limit negative environmental externalities.
A third, related reason is that it is not growth itself that is bad for the environment, but rather the ways that growth is pursued. If growth were pursued differently, it need not conflict with environmental sustainability.
A fourth reason is that growth based on unsustainable resource use may lead to destruction of natural resources on such a wide scale that the possibility of continued future growth may be threatened.
What are the conditions that allow economic growth and environmental sustainability to se safely pursued?
Modern growth theory shows that economic growth and environmental sustainability are in fact consistent with each other, and can be successfully pursued together under certain conditions, such as the following:
1. Governments implement market-based policies that 'internalise the externalities', thus not only correcting them (at least in part) but also providing incentives for sustainable resource use and promotion of green (or 'clean') technologies.
2. Governments pursue more environmental regulations that encourage pollution-free technological change (green technologies).
3. There is an increased emphasis on human capital in production (which is pollution-free) as opposed to physical capital.
4. An increased emphasis on 'green' investments, which promote growth while not hurting the environment: building public transportation systems; investing in insulation in homes and buildings; investing in clean technology research and development (R&D) and clean technologies.
5. There are changes in the structure of the
economy toward more services (which tend to be pollution-free), together with more investments in the protection of natural resources.
OVERALL impact of economic growth and sustainability
As incomes increase with economic growth,
more resources are made available with which governments can pursue the above kinds of policies, encouraging economic growth at the same time
that they encourage sustainability. Therefore, economic growth and sustainability can be pursued together provided governments take appropriate measures to ensure sustainable resource use. This is the very meaning behind the concept of 'sustainable development'.
However, even under the best possible circumstances where all of the conditions for successful economic growth are fulfilled, modern growth theories show that there is a maximum rate of growth that is consistent with environmental sustainability, and that if an economy exceeds this rate, resource use will become unsustainable. The reason is that pursuit of sustainability uses up some resources (for example anti-pollution controls), and these resources represent an opportunity cost in terms of lost economic growth. Note, however, that this only applies to a loss of a portion of very high rates of growth.
A concluding note - economic growth and living standards
Economic growth can be expected to impact on living standards, but improved living standards measured as improvements in human development, involving improved human capital or reduced income inequalities, are major factors contributing to economic growth.
A concluding note - economic growth and unemployment
Economic growth may lower cyclical or structural unemployment, but reductions in unemployment can contribute to economic growth by making better use of available resources (movement closer to the economy's production possibilities curve (PPC).
A concluding note - economic growth and inflation
Economic growth may contribute to a higher rate of inflation, but a high rate of inflation may contribute to lower economic growth, by discouraging investment.
A concluding note - economic growth and the distribution of income
Economic growth can make the distribution of income more or less equal (equitable), but a more equal distribution of income has a positive effect on growth.
A concluding note - economic growth and the current account of the balance of payments
Economic growth may worsen the current account, but a serious current account deficit can lower economic growth by increasing the need for foreign borrowing.
A concluding note - economic growth and sustainability
Economic growth that ignores the effects on the environment leads to environmental unsustainability, but unsustainability also leads to lower economic growth due to destruction of common access resources. On the other hand, economic growth based on the principle of sustainable development leads to environmental preservation, which in turn can be expected to lead to higher economic growth in the future.
A concluding note the impact of economic growth
The likelihood of a two-way causality, where economic growth impacts upon factors such as the above, and where these factors in turn impact upon economic growth, sometimes makes it difficult in the real world to determine what causes what.