Economic_Growth

ECONOMIC GROWTH AND ECONOMIC DEVELOPMENT The terms economic growth and economic development are sometimes used interchangeably, but there is a fundamental distinction between them. We shall examine them one after the other. ECONOMIC GROWTH Economic growth is the increase in value of the goods and services produced by an economy. It is conventionally measured as the percent rate of increase in real gross national product, or GNP. Growth is usually calculated in real terms, i.e. inflation-adjusted terms, in order to net out the effect of inflation on the price of the goods and services produced. In economics, "economic growth" or "economic growth theory" typically refers to growth of potential output, i.e., production at "full employment," which is caused by growth in aggregate demand or observed output. As economic growth is measured as the annual percent change of National Income it has all the advantages and drawbacks of that level variable. But people tend to attach a particular value to the annual percentage change, perhaps since it tells them what happens to their wage cheque. | | [pic]Origins of the concept of economic growth In the early modern period, some people in Western European nations began conceiving of the idea that economies could "grow", that is, produce a greater economic surplus which could be expended on something other than religious or governmental projects (such as war). The previous view was that only increasing either population or tax rates could generate more surplus money for the Crown or country. Now it is generally recognized that economic growth also corresponds to a process of continual rapid replacement and reorganization of human activities facilitated by investment motivated to maximize returns. This exponential evolution of our self-organized life-support and cultural systems is remarkably creative and flexible, but highly unpredictable in many ways. Since science still has no good way of modeling complex self-organizing systems, various efforts to model the long term evolution of economies have produced few useful results. During much of the "Mercantilist" period, growth was seen as involving an increase in the total amount of specie, which is circulating medium such as silver and gold, under the control of the state. This "Bullionist" theory led to policies to force trade through a particular state, the acquisition of colonies to supply cheaper raw materials which could then be manufactured and sold. Later, such trade policies were justified instead simply in terms of promoting domestic trade and industry. The post-Bullionist insight that it was the increasing capability of manufacturing which led to policies in the 1700's to encourage manufacturing in itself, and the formula of importing raw materials and exporting finished goods. Under this system high tariffs were erected to allow manufacturers to establish "factories". (The word comes from "factor", the term for someone who carried goods from one stage of production to the next.) Local markets would then pay the fixed costs of capital growth, and then allow them to export abroad, undercutting the prices of manufactured goods elsewhere. Once competition from abroad was removed, prices could then be increased to recoup the costs of establishing the business. Under this theory of growth, the road to increased national wealth was to grant monopolies, which would give an incentive for an individual to exploit a market or resource, confident that he would make all of the profits when all other extra-national competitors were driven out of business. The "Dutch East India company" and the "British East India company" were examples of such state-granted trade monopolies. It should be stressed that Mercantilism was not simply a matter of restricting trade. Within a country, it often meant breaking down trade barriers, building new roads, and abolishing local toll booths, all of which expanded markets. This corresponded to the centralization of power in the hands of the Crown (or "Absolutism"). This process helped produce the modern nation-state in Western Europe. Internationally, Mercantilism led to a contradiction: growth was gained through trade, but to trade with other nations on equal terms was disadvantageous. This – along with the rise of nation-states – encouraged several major wars. The modern conception of economic growth began with the critique of Mercantilism, especially by the physiocrats and with the Scottish Enlightenment thinkers such as David Hume and Adam Smith, and the foundation of the discipline of modern political economy. The theory of the physiocrats was that productive capacity, itself, allowed for growth, and the improving and increasing capital to allow that capacity was "the wealth of nations". Whereas they stressed the importance of agriculture and saw urban industry as "sterile", Smith extended the notion that manufacturing was central to the entire economy. David Ricardo would then argue that trade was a benefit to a country, because if one could buy a good more cheaply from abroad, it meant that there was more profitable work to be done here. This theory of "comparative advantage" would be the central basis for arguments in favor of free trade as an essential component of growth. This notion of growth as increased stocks of capital goods (means of production) was codified as the Solow-Swan Growth Model, which involved a series of equations which showed the relationship between labor-time, capital goods, output, and investment. In this modern view, the role of technological change became crucial, even more important than the accumulation of capital. Income per capita was essentially flat until the industrial revolution. This period of time is called the Malthusian period, since it was governed by the principles explained by Thomas Malthus in his "Essay on the Principle of Population." In essence, Malthus said that any growth in the economy would translate into a growth in population. Thus, although aggreagate income could increase, income per capita was bound to stay roughly constant. The mainstream theory of economic growth states that with the industrial revolution and advancements in medicine, life expectation increased, infant mortality decreased, and the payoff to receiving an education was higher. Thus, parents began to place more value on the quality of their children and not on the quantity. This lead to a drop in the fertility rates of most industrialized nations. This is known as the breakdown of the Malthusian regime. With income increasing drastically and population dropping, industrialised economies drastically increased their incomes per capita in the next centuries. The late 20th century, with its global economy of a few very wealthy nations, and many very poor nations, led to the study of how the transition from subsistence and resource-based economies, to production and consumption based-economies occurred, leading to the field of Development economics. Measurement of Economic Growth Economic growth can be measured in a number of ways: Gross National Product (GNP) One of the methods of measuring economic growth is the GNP. This measures total income earned by domestic citizens regardless of the country in which their factor services were supplied. However, the appropriateness of this indicator has been questioned, based on the following reasons: This measure fails to take changes in the growth of the population into consideration. For instance, if a rise in real national income is accompanied by a faster growth in population, there will be no economic growth but retardation. The GNP figure does not reveal the costs of environmental pollution, urbanisation, industrialisation, and population growth. It says nothing about the distribution of income in the economy. There are also certain conceptual difficulties in the measurement of GNP, such as: 10 GNP is always measured in monetary terms, but there are a number of services which are difficult to measure in monetary units. 11 The failure of GNP to properly distinguish between final and intermediate products also raises the issue of double counting. Hence there is the fear of a good or service being included more than once. 12 GNP makes no distinction between such valuable services, such as bringing up children and manufacture of products such as wine or cigarettes which may be injurious to human health. 13 Income earned through illegal activities such as gambling, bribery, illicit extraction of wine, etc is not included in the measurement of GNP. 14 Capital gains or losses which accrue to property owners, by increases or decreases in the market value of their capital assets or changes in demand are excluded from the GNP since such changes do not result from current economic activities. [It is only when capital gains or losses are the result of the current flow or non-flow of productive activities that they are included in its calculation]. GNP Per Capita GNP per capita is GNP divided by the total population. Economists often look at economic development in terms of an increase in per capita real income or output. For example, Meier defines economic development “as the process whereby the real per capita income of a country increase over a long period of time-subject to the stipulation that the number of people below an ‘absolute poverty line’ does not increase, and that the distribution of income does not become more unequal” This indicator of economic growth believes that the rate of increase in real per capital income should be higher than the population growth rate. The real GNP per capita is the most widely used measure of economic development. [The real GNP (or GNP in constant prices or Naira) measures the Naira value of goods and services sold in a given year in terms of prices at which those goods sold in some base or benchmark year] However, there are some problems in using growth in GNP per capita to measure general well being. 17 An increase in per capital income may not necessarily raise the real standard of living of people. For instance, it is possible that while per capita real income is increasing, per capita consumption might be falling. People might be increasing the rate of saving or the government might be using up the increased income for military or other purposes. 18 The people might remain poor in the face of an increased GNP per capita if the increased income goes to the few instead of going to the generality of the people. 19 GNP per capita subordinates other questions regarding the structure of the society, the size and composition of its population, its institutions and culture, the resource patterns and even distribution of outputs among members of the society. 20 The real per capita income estimates fails to adequately measure changes in output due to changes in the price level. Index numbers used to measure changes in the price level are mere rough approximations. In addition, the price levels vary in different countries. Consumers’ wants and preferences are also different across countries. 21 The real GNP per capita fails to take into account, problems associated with basic needs such as nutrition, health, sanitation, housing, water and education etc. • GDP per capita does not provide any information relevant to the distribution of income in a country. • GDP per capita does not provide any information relevant to the distribution of income in a country. • GDP per capita does not take into account positive externalities that may result from services such as education and health. • GDP per capita excludes the value of all the activities that take place outside of the market place (such as cost-free leisure activities like hiking). The flaws of GNP/GNP per capita may be important when studying public policy; however, for the purposes of economic growth in the long run they tend to be very good indicators. There is no other indicator in economics which is as universal or as widely accepted as these measures. Social Indicators Economists are well aware of the various deficiencies in GNP/GNP per capita, thus, the indices should always be viewed merely as indicators and not absolute scales. In this regard therefore, some economists have attempted to measure economic growth in terms of social indicators. A wide variety of items have been used in the construction of social indicators. These are generally classified into two: “inputs” and “outputs”. Inputs comprise of such items as nutritional standards or number of hospital beds, or doctors per head of population. Corresponding to the “inputs” are outputs such as improvement in health in terms of infant mortality rates, sickness rate, etc. Hicks and Streeten (1979) employed six of such indicators: Basic Need Indicator 1. Health Life expectancy at birth 2. Education Literacy signifying primary school enrolment as percent of population 3. Food Calorie supply per head 4. Water Supply Infant mortality and percentage of population with access to portable water 5. Sanitation Infant mortality and percentage of population with access to portable water 6. Housing None It should be noted that social indicators are usually referred to as the basic needs for development. Basic needs focus on alleviation of poverty by providing basic human needs to the poor. It has also been observed that direct provision of such basic needs as health, education, food, water, sanitation and housing goes a long way in alleviating poverty in a shorter period and with fewer financial resources than the GNP/GNP per capita strategy. In addition, basic needs often lead to a higher level of productivity and income through human development in the form of educated and healthy people. One major advantage of social indicators is that they are concerned with the ends, i.e. human development. Social indicators give some insight into the allocation of a county’s national income among different alternatives. In particular, they give information about the presence, absence, as well as the deficiency of certain needs. Like other measures already discussed, social indicators also have their limitations: • There is no consensus among economists with reference to the number and type of items to be included in such an index. • There is also the problem of assigning weights to the various items. This generally depends on the social, economic and political set-up of a particular country. • Social indicators are concerned with current welfare, hence may not be useful for the future. • Majority of the indicators are inputs and not outputs, such as education, health, etc. • They involve value judgments. Economists have tried to measure social indicators of basic needs by taking one or more indicators for the purposes of constructing composite indices of human development. Examples of such include the Physical Quality of Life Index (PQLI) and the Human Development Index. [See the attachment on PQLI]. Theories of Economic Growth The short-run variation of economic growth is termed the business cycle, and almost all economies experience periodic recessions. Explaining and preventing these fluctuations is one of the main focuses of macroeconomics. A statistical relationship called Okun's law relates the growth rate of an economy to the level of unemployment. On a Keynesian view, growth varies because of changes in aggregate demand, causing firms to produce more or less goods for sale and hence altering the size of the economy. The contrasting real business cycle model suggests that in the short run growth depends on a series of shocks to the productivity of the economy, e.g. an oil price rise making the economy generally less productive and reducing growth. The long-run path of economic growth is one of the central questions of economics; in spite of the problems of measurement, an increase in GDP of a country is generally taken as an increase in the standard of living of its inhabitants. Over long periods of time, even small rates of annual growth can have large effects through compounding (see exponential growth). A growth rate of 2.5% per annum will lead to a doubling of GDP within 28 years, whilst a growth rate of 8% per annum (experienced by some East Asian Tigers) will lead to a doubling of GDP within 9 years. The neo-classical growth model, developed by Robert Solow in the 1950s, was the first attempt to model long-run growth analytically. This model assumes that countries use their resources efficiently and that there are diminishing returns to capital and labor increases. From these two premises, the neo-classical model makes three important predictions. First, increasing capital relative to labor creates economic growth, since people can be more productive given more capital. Second, poor countries with less capital per person will grow faster because each investment in capital will produce a higher return than rich countries with ample capital. Third, because of diminishing returns to capital, economies will eventually reach a point at which no new increase in capital will create economic growth. This point is called a "steady state." The model also notes that countries can overcome this steady state and continue growing by inventing new technology that allows production with fewer resources, but the model assumes technological progress, "exogenizing" technology from the model. Unsatisfied with Solow's explanation, economists worked to "endogenize" technology in the 1980s. They developed the endogenous growth theory that includes a mathematical explanation of technological advancement. This model also incorporated a new concept of human capital, the skills and knowledge that make workers productive. Unlike physical capital, human capital has increasing rates of return. Therefore, overall there are constant returns to capital, and economies never reach a steady state. Growth does not slow as capital accumulates, but the rate of growth depends on the types of capital a country invests in. Research done in this area has focussed on what increases human capital (e.g. education) or technological change (e.g. innovation). The growth can be explained by two different sources. One is factor accumulation or "working harder" which means the growth simply comes from an increase in labor, land, capital, or any factor endowment. The other source comes from improvements in efficiency or "working smarter" which means there has been a development in technology that brings increasing returns to scale. There is common misconception that the positive correlation between high income and cold climate is causal, when in fact it is a by-product of history. Former colonies have inherited corrupt governments and geo-political boundaries (set by the colonizers) that are not properly placed regarding the geographical locations of different ethnic groups; this creates internal disputes and conflicts. Colonies in temperate climate zones as Australia and USA did not inherit exploitative governments since Europeans were able to inhabit these territories and set up governments that mirrored those in Europe. Thus, we observe a correlation between high incomes and average temperatures but the correlation is, again, not casual and a mere reflection of the product of colonization. Jared Diamond attempts to explain, in his book Guns, Germs and Steel, why it was that some groups were able to colonize others. He argues that Eurasia was much more advanced because it had a larger surface area that had a common climate (oriented from east to west as opposed to America which is oriented from North to South,) they had more domesticable animals. This advantage in size and agro-technologies translated in the long run into advantages that allowed them to become militarily stronger than other groups. ECONOMIC DEVELOPMENT We have earlier defined economic growth as a rise in the national or per capita income and products. For example, if the production of goods and services in a country rises, by whatever means, one can speak of that rise as economic growth. Economic development implies more. It is a sustainable increase in living standards that implies increased per capita income, better education and health as well as environmental protection. Economic development can be seen as a complex multi-dimensional concept involving improvements in human well-being – however defined. Critics point out that GNP is a narrow measure of economic welfare that does not take account important non-economic aspects such as more leisure time, access to health & education, the environment, freedom, or social justice. Economic growth is a necessary but insufficient condition for economic development. Professor Dudley Seers argues that development is about outcomes, that is, development occurs with the reduction and elimination of poverty, inequality, and unemployment within a growing economy. Professor Michael Todaro sees three objectives of development: • Producing more ‘life sustaining’ necessities such as food, shelter, and health care and broadening their distribution • Raising standards of living and individual self esteem • Expanding economic and social choice and reducing fear The UN has developed a widely accepted set of indices to measure development against a mix of composite indicators: • UN’s Human Development Index (HDI) measures a country’s average achievements in three basic dimensions of human development: life expectancy, educational attainment, and adjusted real income ($PPP per person). • UN’s Human Poverty Index (HPI) measures deprivation using the percent of people expected to die before age 40, the percent of illiterate adults, the percent of people without access to health services and safe water and the percent of underweight children under five Public policy generally aims at continuous and sustained economic growth and expansion of national economies so that ‘developing countries’ become ‘developed countries’. The economic development process supposes that legal and institutional adjustments are made to give incentives for innovation and for investments so as to develop an efficient production and distribution system for goods and services. The distinction between economic growth and economic development can be made clearer by examining these concepts in two countries: South Korea and Libya. What has been happening in South Korea since 1960, for example, is fundamentally different from the situation in Libya as result of the discovery of petroleum. It is a fact that both countries experienced a large rise in per capita income. However, in Libya, this rise was achieved by foreign corporations staffed largely by foreign technicians who produced a single product consumed mainly in the United States and Western Europe. Though the government and people of Libya have received large amounts of income from their oil, they have little to do with producing that income. Libya’s experience is not usually described as economic development. In the real sense of the word, in addition to a rise in per capita income, economic development implies fundamental changes in the structure of the country, of the kind observed in South Korea since 1960 [see the attachment on South Korea]. Two of the most important of these structural changes are the rising share of industry (along with the falling share of agriculture in national product) and an increasing percentage of people who live in cites rather than the country side. In addition, it has been observed that countries that enter into economic development usually pass through periods of accelerating, then decelerating population growth during which the nation’s age structure changes dramatically. Consumption patterns also change as people no longer have to spend all their income on necessities, but instead move on to consumer durables and eventually to leisure time products and services. A key element in economic development is that the people of the country must be major participants in the process that will bring about these changes in structure. Foreigners can be and inevitably are involved as well, but they cannot be the main actors. In essence, participation in the process of development implies participation in the enjoyment of the benefits of development, as well as the production of those benefits. It should also be noted that if growth benefits a tiny, wealthy minority, whether domestic or foreign, this is not development. SOURCES OF LONG-RUN GROWTH Ultimately, long-run economic growth is the most important aspect of how an economy performs. Material standards of living and levels of economic productivity in the developed countries are as a result of favourable initial conditions and successful growth-promoting policies over the past two centuries. For example, material standards of living and levels of economic productivity in the United States today are at least five times what they were at the end of the 19th century and more than ten times what they were at the founding of the republic. Economic history has shown that policies and initial conditions work to accelerate or retard growth through two principal channels. The first is their impact on the available level of technology that multiplies the efficiency of labour. The second is their impact on the capital intensity of the economy, i.e. the stock of machines, equipment, and buildings that the average worker has at his or her disposal. Better Technology The overwhelming part of the reasons why Americans today are more productive and better off than their predecessors of a century or two ago is “better technology”. For instance, they now know how to make electric motors, dope semi-conductors, transmit signals over fibre optics, fly jet airplanes, make internal combustion engines, build tall and durable structures out of concrete and steel, record entertainment programmes on magnetic tape, make hybrid seeds, fertilize crops with better mixture of nutrients, organise assembly lines fro mass production, and do a host of other things their predecessors did not know how to make a century or so ago. Perhaps more important, the American economy is equiped to make use of all these technological discoveries. Better technology leads to a higher level of efficiency of labour (i.e. the skills and education of the labour force, ability of the labour force to handle modern machines technologies, and the efficiency with which the economy’s businesses and markets function. It is obvious that an economy in which the efficiency of labour is higher will be a richer and a more productive economy. This technology-driven overwhelming increase in the efficiency with which Americans work today is the major component of their current relative prosperity. Capital Intensity The second major factor determining the prosperity and growth of an economy and the second channel through which changes in economic policies can affect long-run growth, is the capital intensity of the economy. For instance, how much does the average worker have at his or her disposal in the way capital goods (such as buildings, freeways, docks, cranes, dynamos, numerically-controlled machine tools, computers, molders, and all the others' The larger the answer to this question, the more prosperous an economy will be. Hence, a more capital intensive economy will be a richer and a more productive economy. There are in turn, two principal determinants of capital intensity. The first is the investment effort being made in the economy: the share of total production (i.e. real GDP) saved and invested in order to increase the capital stock of machines, buildings, infrastructure, and other man-made tools that amplify the productivity of workers. Policies that create a higher level of investment effort lead to a faster rate of long-run economic growth. The second determinant is the investment requirements of the economy: the amount of new investments that goes to equipping new workers with the economy’s standard level of capital or to replacing worn-out and obsolete machines and buildings. The ratio between the investment effort and the investment requirements of the economy determines the economy’s capital intensity. Models of economic development The three building blocks of most growth models are: (1) the production function, (2) the saving function, and (3) the labor supply function (related to population growth). Together with a saving function, growth rate equals s/ß (s is the saving rate, and β is the capital-output ratio). Assuming that the capital-output ratio is fixed by technology and does not change in the short run, growth rate is solely determined by the saving rate on the basis of whatever is saved will be invested. Harrod-Domar Model The Harrod-Domar Model delineates a functional economic relationship in which the growth rate of gross domestic product (g) depends directly on the national saving ratio (s) and inversely on the national capital/output ratio (k) so that it is written as g = s / k. The equation takes its name from a synthesis of analyses of growth process by two economists (Sir Roy Harrod of Britain and Evsey Domar of the USA). The Harrod-Domar model in the early postwar times was commonly used by developing countries in economic planning. With a target growth rate, the required saving rate is known. If the country is not capable of generating that level of saving, a justification or an excuse for borrowing from international agencies can be established. An example in the Asian context is to ascertain the relationship between high growth rates and high saving rates in the cases of Japan and China. It is more difficult to introduce the third building block of a growth model, the labor and population element. In the long run, growth rate is constrained by population growth and also by the rate of technological change. Exogenous growth model The exogenous growth model (or neoclassical growth model) of Robert Solow and others places emphasis on the role of technological change. Unlike the Harrod-Domar model, the saving rate will only determine the level of income but not the rate of growth. The sources-of-growth measurement obtained from this model highlights the relative importance of capital accumulation (as in the Harrod-Domar model) and technological change (as in the Neoclassical model) in economic growth. The original Solow (1957) study showed that technological change accounted for almost 90 percent of U.S. economic growth in the late 19th and early 20th centuries. Empirical studies on developing countries have shown different results (see Chen, E.K.Y.1979 Hyper-growth in Asian Economies). Also see, Krugman (1994), who maintained that economic growth in East Asia was based on perspiration (use of more inputs) and not on inspiration (innovations) (Krugman, P., 1994 The Myth of Asia’s Miracle, Foreign Affairs, 73). Even so, in our postindustrial economy, economic development, including in emerging countries is now more and more based on innovation and knowledge. Creating business clusters is one of the strategies used. One well known example is Bangalore in India, where the software industry has been encouraged by government support including Software Technology Parks. Surplus labor The Lewis-Ranis-Fei (LRF) Model of Surplus Labor (LRF) is an economic development model and not an economic growth model. Economic models such as Big Push, Unbalanced Growth, Take-off, and so forth, are only partial theories of economic growth that address specific issues. LRF takes the peculiar economic situation in developing countries into account: unemployment and underemployment of resources (especially labor) and the dualistic economic structure (modern vs. traditional sectors). This model is a classical model because it uses the classical assumption of subsistence wage. Here it is understood that the development process is triggered by the transfer of surplus labor in the traditional sector to the modern sector in which some significant economic activities have already begun. The modern sector entrepreneurs can continue to pay the transferred workers a subsistence wage because of the unlimited supply of labor from the traditional sector. The profits and hence investment in the modern sector will continue to rise and fuel further economic growth in the modern sector. This process will continue until the surplus labor in the traditional sector is used up, a situation in which the workers in the traditional sector would also be paid in accordance with their marginal product rather than subsistence wage. The existence of surplus labor gives rise to continuous capital accumulation in the modern sector because (a) investment would not be eroded by rising wages as workers are continued to be paid subsistence wage, and (b) the average agricultural surplus (AAS) in the traditional sector will be channeled to the modern sector for even more supply of capital (e.g., new taxes imposed by the government or savings placed in banks by people in the traditional sector). In the LRF model, saving and investment are driving forces of economic development. This is in line with the Harrod-Domar model but in the context of less-developed countries. The importance of technological change would be reduced to enhancing productivity in the modern sector for even greater profitability and promoting productivity in the traditional sector so that more labor would be available for transfer. Harris-Todaro model The Harris-Todaro (H-T) model of rural-urban migration is usually studied in the context of employment and unemployment in developing countries. In the H-T model, the purpose is to explain the serious urban unemployment problem in developing countries. The applicability of this model depends on the development stage and economic success in the developing country. The distinctive concept in the H-T model is that the rate of migration flow is determined by the difference between expected urban wages (not actual) and rural wages. The H-T model is applicable to less successful developing countries or to countries at the earlier stages of development. The policy implications are different from those of the LRF model. One implication in the H-T model is that job creation in the urban sector worsens the situation because more rural migration would thus be induced. In this context, China's policy of rural development and rural industrialization to deal with urban unemployment provides an example.