Encouraging Economic Growth and Prosperity

Introduction

When a country experiences economic crisis, its production capacity shrinks as the consumers’ power to spend is reduced. A country in such situation records low economic growth and high unemployment rates. Economic growth will only occur when the government takes the country’s resources and rearrange them to gain more value. Numerous studies have proved that income per person is closely related to the key measures of economic growth. The emergence of Keynesian theory enabled economists to understand causes of economic crisis, and to offer solutions to effects of recession and depression. Achieving high economic growth is the central focus of any national economic policy, as booming economic growth is essential for balancing the budget. This study will focus on defining economic growth and its measure, in addition to explaining various economic policy tools that encourages economic growth.

Economic Growth and its Measurement

Defining Economic Growth

When a country experiences a rise in the capital stock, levels of technology, literacy, and overall productive capacity, the country is said to be experiencing economic growth. According to Nafziger (2012, 44), economic growth involves the rise in the country’s per capita income. A country that has experienced economic growth has enough products for its people while large number of the population is employed. If a country is not experiencing economic growth, the living standards of its people remain stagnant, as many people fall into poverty.

Economic growth is fundamental for business growth and prosperity. When the output of the entire economy increases, the country is assured of economic growth. According to the Keynesian theory, aggregate demand is the most essential driving force to a sound economy, and include the spending by the households, businesses, as well as the government (Jahan, S., Mahmud, A. & Papageorgiou, C. 2014, 53). The level of employment is essential in determining economic growth since contraction of economic activities may lead to low levels of output and a fall in employment rates. A period of recession occurs when there is a fall in output, in addition to employment rates.

Economic growth has enabled countries to acquire resources that enabled them to reduce incidences of pollution and conserve their environment without interfering with the standards of living (Ferrara, P. 2014). Government intervention enhances economic growth by implementing public policies that focus on achieving full employment and stabilizing prices. A high economic growth means surging GDP, which can reduce the national debt, and balance the budget. Economic growth has been utilized by newly independent countries to mobilize their resources in order to enhance their national power (Nafziger, E. 2012, 43).

Measuring Economic Growth

Before tackling the issue of economic policymaking, it is crucial to assess how economists measure economic growth and performance in the country. Measuring economic growth involves assessing the growth of either total output of the country, or the total income. Thus, the most common and acceptable units for measuring economic growth include the Gross National Income (GNI), and the Gross Domestic Product (GDP) (Cypher, J. 2000, 37). GNI is the total value of income accumulated by all residents of a country in a year, plus income that comes from abroad and product taxes. GDP is the total income accumulated within the country’s border in a year, regardless of whether the person receiving such income stays within or outside the borders of that country. The difference between GNI and GDP is the net income received from abroad, which is incorporated in the GNI.

All products that are manufactured by foreign firms are added to the nation’s GDP, just like products manufactured by domestic industries. However, calculation of GDP does not incorporate the value of capital gains or losses in real estate and financial securities. Capital gains can be realized or unrealized. Although realized capital gains can generate cash that could be spent in the country, they do not alter economic output (Gosling, J. 2014, 22). Unrealized capital gains can raise the market value of an asset hence have economic value. The well-being of a country is measured by considering the size of the economy and the direction that the rate of change in output is taking. When comparing economic growth of one country to another, knowing the population as well as the currency values of each country is important.

Economists exploit numerous indicators of economic performance, such as income, output, investment, saving, unemployment, workers’ productivity, and inflation. However, GDP cannot be calculated without determining the market value of several goods and services. GDP is represented in the equation Y=C+I+G+NX, where Y is GDP, C is consumer spending, I is investment, G is government spending, and NX is net exports, or the difference between the country’s exports and imports. A growing economy has more exports than imports, hence, enjoying a balance of trade. GDP can also be termed as total consumption, which incorporates consumer spending, business investment, government expenditure, and net exports.

Economic growth has the capacity to reduce poverty through enhancing employment opportunities as well as increasing labor productivity. People are happier when the GDP per capita is high, as high GDP per capita enable them to have variety of products and services to choose. The level of personal income affects economic growth because the decline in personal income leads to low demand for goods, as well as services in an economy.

Economic Policy Tools

The Obama administration in the US came into power in January 2009 when the US was already in struggling with recession for a year while the GDP was falling. Thus, the first duty for the US government was to guarantee citizens of brighter future. Essentially, policies that could be utilized to ensure an increase in economic growth have to raise the aggregate demand, or aggregate supply. The US case should have utilized the demand side policy while the supply side policy is essential when determining long run productivity growth. The government is responsible for ensuring that the country has attained economic growth using the two main economic tools. These tools include:

1. Monetary policy
2. Fiscal policy

A.    Monetary policy

Monetary policy is among the most common tools that economists use in regulating economic activities in a country. This policy incorporates the Central Bank’s act of adjusting the interest rate to influence money supply to the economy. To increase aggregate demand, the Central bank cuts the interest rates, whereas to encourage consumer spending and investment, the Central Bank lowers interest rates to minimize the cost of borrowing. Thus, the monetary policy influences what the public holds at a given time. In addition, monetary policy is usually adjusted once in every month. Monetary policy analysis begins from understanding the role of central banks as creators of means of payment.

Monetary policy can be either expansionary or contractionary. Expansionary monetary policy involves lowering interest rates through open-market operations of T-bill, while contractionary monetary policy actions focus on raising interest rates through open-market sales. When the Federal Reserve anticipates that the economy might move to a recession, it can opt to raise the supply of bank reserves (Baumol, W. & Blinder, A. 2015, 272). This action can be carried out by buying T-bills through the open market, thus, shifting the supply schedule outward, as illustrated in Figure 1(a). This action was witnessed during the financial crisis of 2007-2008, when the Fed increased money supply to the economy to avoid severe recession.

Fig: Expansionary and Contractionary Monetary Policy

Expansionary monetary policy can also occur through the discount rate where Reserve banks offer discounted interest rates to commercial banks for short period loans. Lower rates of discounted interest encourage lending, as well as consumption. The Fed can opt to reverse the process through contracting bank reserves, which in turn reduces money supply. This can be done through increasing the level of interest rates, which causes business investments to fall while pushing the aggregate demand down through the multiplier effect. The Fed rarely calls for a change in reserve requirements, as this is the responsibility of the Board of Governors. In the short-run, central banks can influence inflation, as employers will seek more employees to produce more goods since they have an access to cheap loans from commercial banks.

Monetary policy affects how the government spends its money. Out of the four components of consumption formula (which is also called aggregate demand), investment and net exports happen to be the most responsive to the monetary policy (Baumol, W. & Blinder, A. 2015, 271). Investments include both business and housing investments, thus, a higher interest rate will reduce the expenditure on housing investment. Rate of interest on borrowing is incorporated in the cost of investment, thus, business executives will reduce their level of investment when the interest rates are increased. Higher interest rates discourage borrowing, as the cost of borrowing will go up. Low levels of borrowing result to decline in investment, which lead to lower aggregate demand, as well as lower inflation.

As one of its numerous monetary policy objectives, the Federal Reserve Act proposed that the Federal Reserve System should maintain moderate long-term interest rates (Abdymomunov, A. & Kang, K. 2015, 183). In case of recession, the Fed is permitted to cut interest rates to encourage consumer spending and investment. On the contrary, during recession, implementing monetary policy by lowering interest rates can result to liquidity trap, where banks do not prefer to lend money while consumers fear to spend. Relying on monetary policy alone during recession may not restore equilibrium in an economy, as government spending is necessary to create demand.

B.     Fiscal policy

Fiscal policy works when the government alters tax rates, as well as its spending to affect the aggregate demand. Fiscal policy originated from the Keynesian economic theory, which asserted that governments could alter the macroeconomic productivity levels through increasing or reducing tax levels, as well as public expenditure. Keynes claimed that inadequate overall demand was destructive, as it could lead an economy to an extended period of high unemployment (Jahan, S., Mahmud, A. & Papageorgiou, C. 2014, 53).The most essential role of fiscal policy is to mitigate unemployment and stabilize the economy. Aggregate demand can be influenced by various economic decisions, both in public and private operations, thus, requiring active policies from the government to regulate consumer spending.

However, fiscal policy is normally affected by the politics of the country, since the government has to either wait for an implementation of legislation, or use the existing legislations, to affect the policy. The political theory emphasizes that policy decisions are normally implemented in every period by legislature that incorporates representatives from all parts of the country. In the US, the Congress decides on matters concerning tax and spending assessments. In 2008, the US economy went into a recess, but six months passed before the Congress could decide to pass the Stimulus Package while another six months ended before making substantial changes to allow expenditure (Kendrick, D. & Amman, H. 2014, 7). The Obama administration opted to follow the Bush administration’s steps in stabilizing the financial market through cutting taxes, in addition to increasing government spending to sustain aggregate demand and raise GDP that in turn raised employment (Parker, J. 2011, 703).

Economic downturns are likely to expose a country into unsustainable fiscal practices. Before the Great recession of 2007-09, stable spending growth had surpassed personal income growth for 37 states, but large budget deficits, as well as fiscal crises reached a new height during the Great Recession, causing a drop in revenue collections (Merrifield, J. & Poulson, B. W. 2014, 48). A rapid state spending was necessary to enhance personal income growth, as an income-growth-based cap limits political interference when economic growth is perceived normal. Although the government incurred a high cost by cutting taxes and increasing public production, such actions enhanced creation of jobs, thus, reducing unemployment rate.

When inflation becomes severe to an economy, the government can exercise fiscal policy to raise taxes to reduce money in the economy. Fiscal policy can also compel the government to reduce its spending, hence, reducing the money in circulation. However, the long run effects of fiscal policy include sluggish economy, as well as high unemployment levels. A tax cut may an effect on one class –the middle class – rather than the entire population while adjusting government spending may also touch on a particular group of people. For instance, when the government increases spending on road construction, hundreds of people will get employment opportunities while installing a radiotherapy machine in a public hospital will have little effect on unemployment rate.

Conclusion

Economic growth involves the capacity for a country to produce adequate amount of goods and services for its people while monetary and fiscal policies are economic tools that enhance such growth. Economic growth is measured by the level of output that a country produces within a year, regardless of the location of the income earners. Although monetary and fiscal policies usually aim at promoting economic growth and enhancing full employment, but in case of inflation, they offer different ideas. Monetary policy involves the act of central banks in regulating money supply in an economy. Fiscal policy originate from Keynesian economics, which emphasizes that governments have the capacity to influence economic activities in a country through raising or reducing tax levels and public expenditure. Sometimes, using both monetary and fiscal policies may be necessary as using either of the two may not be sufficient to bring an economy to equilibrium.

References

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Baumol, W. J. & Blinder, A. S., 2015. Macroeconomics: Principles and policy. Boston, MA: Cengage Learning.

Ferrara, P., 2014. Why Economic Growth Is Exponentially More Important Than Income Inequality, Forbes [Online] (updated 14 Jan. 2014) Available at: <http://www.forbes.com/sites/peterferrara/2014/01/14/why-economic-growth-is-exponentially-more-important-than-income-inequality/> [Accessed 29 Apr. 2015].

Gosling, J. J., 2008. Economics, politics, and American public policy. Armonk, N.Y: M.E. Sharpe.

Jahan, S., Mahmud, A. S. & Papageorgiou, C., 2014. What Is Keynesian Economics? International Monetary Fund [Online] (updated September 2014) Available at: < http://www.imf.org/external/pubs/ft/fandd/2014/09/basics.htm> [Accessed 1May 2015].

Kendrick, D. A., & Amman, H. M., 2014. Quarterly Fiscal Policy. Economists’ Voice, 11(1), 7-12.

Merrifield, J. & Poulson, B. W., 2014. State Fiscal Policies for Budget Stabilization And Economic Growth: A Dynamic Scoring Analysis. CATO Journal, 34(1), 47-81.

Nafziger, E. W., 2012. Economic development. Cambridge: Cambridge University Press.

Parker, J. A., 2011. On measuring the effects of fiscal policy in recessions. Journal of Economic Literature, 49(3), 703-718.