Economic Growth
Welcome to this section exploring economic growth! We will explore several areas of growth, including its definition and how it is measured, and the benefits and costs it has for the economy as a whole. Furthermore, we will outline ways in which governments may try to increase economic growth and explore the ‘business cycle’. The SQA Higher Economics specification for this section
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What is Economic Growth?
In the Economic Futures Hub, we previously introduced Gross Domestic Product (GDP). The term economic growth typically refers to GDP growth, and GDP is a measure of the size a country’s economy. It can also be used to compare the size of different economies. An annual GDP growth rate of 3%, quite simply, indicates that the economy has grown by 3% on the previous year.
Economic Growth in the United Kingdom:
This graph, showing the UK’s GDP growth rates in the 21st century, clearly displays that GDP growth rates are at their lowest levels during ‘bad times’ in the economy. During both the 2008 financial crisis, and the 2020 Covid-19 pandemic, we can see that growth in the economy fell substantially.
What does Economic Growth Indicate?
- Economic growth is associated with rising income and increased employment opportunities, as well as increasing investment
- A combination of the above factors present the opportunity for individuals living standards to rise, this may not equate to equally rising living standards however
- Higher economic growth indicates that output in the economy is higher
What do we mean when we say output?
- Economists refer to output as the quantity of goods and services produced in the economy
- Output is a key indicator of a country’s performance
- High output indicates that production is higher
The Fraser of Allander Institute regularly publish economic outlooks, forecasting future economic growth levels, and highlighting what current and expected economic conditions mean for Scotland’s economy.
What is the Business Cycle?
The business cycle refers to the cyclical pattern of economic expansion and contraction that we often witness in the economy. It is a common and natural feature of most economies worldwide. There are 4 key stages of the Business Cycle and this section will explore each area. The 4 key stages of the cycle are expansion, peak, contraction, and recovery.
Expansion
This phase refers to a significant rise in economic activity including a rise in employment, production, and consumer spending. In this period, business’ experience profit and growth, and consumer confidence is high. An expansion is associated with higher employment and higher aggregate demand. In addition, central banks often set low interest rates to encourage investment and consumption. There is however a risk that rapid economic growth can trigger inflation!
Peak
The peak phase represents the highest point of the business cycle, and when economic activity is at the maximum level. At this point, key economic factors such as GDP, employment and consumer spending are at their highest point. In addition, there is often less people looking for jobs than there are available openings. There may also be high inflation at this point.
The USA Housing Boom: Many of you will have heard of the 2008 financial crisis, but what exactly caused it? In the early 2000’s the USA was in the peak phase of the business cycle, experiencing low unemployment, high economic growth and high demand for housing. During this period, even untrustworthy buyers were offered mortgages which increased demand, leading to soaring house prices. What was to follow the peak phase was rather the opposite!
Contraction
This phase involves a reduction in economic activity which is associated with lower consumer spending, rising unemployment and decreased production. As consumer demand and profitability decrease, businesses decrease their production and let go of employees, causing higher unemployment. The above factors result in negative economic growth, otherwise known as a contraction in GDP.
The Financial Crisis: As the peak phase transitioned in to the contraction phase, those who had taken mortgages could not repay their loans. Resultantly, financial institutions lost significant amounts of money and some collapsed fully, leading to significant job losses. Furthermore, it became very difficult for people/firms to borrow money. Subsequently, people had significantly less money to spend, unemployment was high, and the stock market collapsed. This is one of the most clear-cut recent examples of the contractionary phase.
The following graph clearly displays the business cycle within the USA. In the early 2000’s the USA was in the expansion and peak phases, experiencing high growth and lower unemployment rates. However, we can see that after the 2008 financial crisis the country entered the contraction phase and experienced significantly increasing unemployment, and decreasing economic growth.
The above is a very simple explanation of the 2008 financial crisis, and there were a number of other factors involved. If you want to learn more about the causes and impacts of the financial crisis, follow this link:
Recovery
The final phase refers to the period following the contractionary phase, where the economy begins to recover and transition to growth. In this phase, there is an increase in GDP growth, increased consumer demand, and improvements in employment. At this stage, various factors contribute to the recovery including increasing consumer confidence, fiscal policy and monetary policy.
Improving Economic Growth and Output
Many of you will have heard numerous political leaders discussing the need to prioritise economic growth. But what do they mean by this? And how might they set out to achieve higher economic growth? This section will explore the wide variety of routes that can be undertaken to improve economic output.
What might the government do to improve economic growth?
- Human Capital Investment - Human capital refers to the skills and ability that people possess. The government may seek to improve this by offering training or scholarship programmes.
- Physical Capital Investment - Physical capital is the physical resources used in the production of goods and services, such as machinery or vehicles.
- Infrastructural Investment - Infrastructure is the physical building blocks of society, including roads, bridges, hospitals and schools.
- Research and Development - The process of researching and creating new knowledge, products, or technologies through study and experimentation.
- Monetary Policy - The actions taken by the central bank to control money supply and interest rates to control inflation and growth.
- Fiscal Policy - This includes government actions relating to government spending and taxation which impact the economy.
How might the government improve economic growth and output?
Human Capital Investment
Human capital refers to the skills and ability that people in the economy possess. The government may seek to improve this by offering training or scholarship programmes. By improving the quality of human capital in the economy, the government aims to improve productivity and subsequently growth.
Human Capital Investment:
A recent way in which the Scottish Government is investing in human capital, is through their extensive apprenticeships scheme offered to young people. The government invests around £100 million every year on apprenticeship training, providing work experience and skills development. This investment both tackles youth unemployment, and can improve the quality of the labour force.
Do you want to learn more about the apprenticeships offered in Scotland? Follow the link below:
Physical Capital Investment
Physical Capital Investment: Physical capital is the physical resources used in the production of goods and services, such as machinery or vehicles. By improving the quality of physical capital in the economy, this is likely to increase growth/output and economic performance. The government may wish to encourage businesses to invest in physical capital and machinery to improve growth. One way which they can do this is by providing tax incentives in the form of tax breaks. By reducing the tax requirements of firms, costs decrease which may lead to investment in technology and other areas.
Infrastructural Investment
Infrastructure is the physical building blocks of society, including roads, schools and hospitals. The government may invest in infrastructure to allow for better flow of economic activity. For example, they may wish to build an enhanced road or rail network to create quicker transport for goods. Infrastructural investment is one example of capital spending, which we also review here in the Economic Futures Hub.
Infrastructural Investment: The Glasgow Commonwealth Games 2014:
Prior to 2014, the Scottish Government invested heavily in infrastructural projects to host the Commonwealth Games successfully. Various infrastructural projects such as the Emirates Arena, Sir Chris Hoy Velodrome, and the SSE Hydro were erected with a cost to the Scottish Government of around £425 million. While costly, the project was estimated to generate increased tourism, trade and employment opportunities. In fact, the Commonwealth Games are estimated to have generated around £740 million for Scotland’s economy.
If you want to learn more about the impact of the games on Scotland’s economic growth:
Research and Development (R&D)
Innovation, creating or implementing new things, is a key driver of improving economic output. The government can incentivise businesses to prioritise research and development which can foster innovation and development. Incentivising R&D can increase investment, create employment opportunities, improve global stature, and improve productivity. A combination of the above impacts can lead to long-term economic growth.
Monetary Policy
Within the Economic Futures Hub, we have explored the use of monetary policy, namely interest rates. One manner in which the central bank can encourage output, is by lowering the interest rates. As we have discussed, lower interest rates means that it becomes cheaper to borrow. Lowering interest rates is associated with increased investments, higher consumer spending and business growth, all which encourage higher economic output.
Fiscal Policy
Fiscal policy involves how the government manages spending and taxation to achieve higher economic output. There are two primary ways in which the government can promote economic growth: government spending and taxation. Firstly, the government may increase spending on schools to improve the long-term education quality and output. This will also create more jobs due to the need for construction, this is known as the secondary effect. Furthermore, the government may decrease taxation which subsequently increases disposable income and consumer spending. Increased spending resultantly promotes higher economic output.
The Fraser of Allander Institute recently published a report outlining the key international economic growth priorities for the Scottish Government, in the International Scotland report:
Growth and Standard of Living
GDP per capita, otherwise known as GDP per head, is one of the most widely used indicators of living standards globally. GDP per capita is simply determined by dividing overall GDP by the population of the country. As such, we can use GDP per capita changes to understand the changes in standards of living. For example, if GDP per capita in Scotland rises significantly, then we would expect that living standards in Scotland would rise accordingly.
GDP and Living Standards: The Debate!
Despite GDP per capita being widely used as the primary indicator of living standards worldwide, there is widespread debate about how effective it is at measuring standards. In this section, we will briefly outline the key criticisms of GDP as a living standard indicator.
Inequality: GDP per capita simply creates an average by dividing GDP equally between the population. This average may mask significant income inequalities in a nation. In nations where there is substantial income inequality, a high GDP per capita may be a misleading measure of the standard of living for the majority of the nation.
While there is a relationship between GDP per capita and income inequality, it is inaccurate to state that higher GDP per capita leads to a decrease in income inequality. This is particularly clear in nations such as the United States and the United Kingdom, where GDP per capita is high yet there is also high income inequality.
Environmental Concerns: It is often the case that higher economic growth correlates with higher emissions. Growth is often associated with increased production and consumption of services, which subsequently, increases the use of fossil fuels such as oil and gas. It is often the case that industry and factory use grows, leading to a rise in emissions. As high growth leads to higher pollution, many argue that it is unfair to indicate that high growth indicates rises in living standards.
The following graph displays GDP per capita and annual emissions in the United Arab Emirates. GDP per capita has increased significantly since 1975, yet annual emissions have also risen by around 650,000%! As skyrocketing emissions has damaging long-term impacts on the global climate, and humanity, is it accurate to suggest that rising GDP per capita leads to rising living standards when there is also rising pollution?
We can see in the above graph that GDP per capita decreased significantly between 2007-2008 during the financial crisis. Such a significant decrease does not necessarily mean living standards plummet in that timeframe.
If Scotland maximised oil mining in the North Sea, this would significantly increase GDP. However, this would also cause substantial environmental damage. Does this rise in GDP then really indicate higher living standards?
The Scottish Government has addressed the need for environmental sustainability to be considered when pursuing economic growth, creating the Wellbeing Economy Governments Group to build the economy while operating within safe environmental limits. Read more about the Wellbeing Economy Governments Group here:
Neglected Factors: GDP measures the monetary value of output in an economy. GDP does not account for social factors such as overall satisfaction/happiness and social cohesion, this is not its purpose. Both factors are of importance to overall standards of living in an economy.
The Benefits of Economic Growth
Increase in Income and Wages: As the economy grows, businesses tend to experience greater profits which allows for them to offer higher wages. This however is not always the case, as businesses may choose to keep higher profits as opposed to offering higher wages.
Decreasing Unemployment: Higher economic growth is also associated with higher employment rates in the economy. As growth rises, businesses often expand operations and increase employment of workers to match demand. Resultantly, unemployment rates are likely to decrease as employment opportunities rise.
Technological Advancements: Economic growth is also associated with technological advancements in the economy. During times of economic growth, businesses often have higher profit levels and are more likely to invest in R&D, machinery and buildings. As business growth and profit rises, we often see an associated rise in technological advancement.
Government Revenue Rises: As we have discussed in the tax section, a higher rate of employment leads to higher total direct taxes paid by workers in the economy. This increases government revenue and benefits budget management. This can benefit the wider economy as the government may choose to increase spending on public services such as health care.
Costs of Economic Growth
The Risk of Inflation: Within The Hub, we have also explored the topic of Inflation. While economic growth can undoubtedly benefit the economy, rapid growth can in fact generate inflationary pressure. Due to high growth, high demand for goods and services can rise faster than supply, which can lead to a rise in prices. High inflation can decrease the value of money and increase the cost of living in the economy.
Sustainability Risks: As we have discussed when outlining the business cycle, constant and rapid economic growth is economically unfeasible. However, extensive economic growth can also have significant environmental costs due to the increase in output which is often associated with increased carbon emissions and pollution.
Inequality Risks: Economic growth does not guarantee an ‘equal’ distribution of wealth, and is unlikely to benefit all portions of society equally. We might predict that high economic growth further benefits the wealthy, and in fact widens the income inequality gap in the country.
What is the Gini coefficient? You will notice that the following graph uses the Gini coefficient to measure income inequality. The Gini coefficient is used as a measure of the level of income inequality in a population. The measure is recorded between 0 and 1 ( 0% and 100%). At 0, there is total equality, while at 1, there is maximum inequality one individual maintains all the wealth. In essence, one individual maintains all the wealth in this scenario. Quite simply, the Gini coefficient allows us to measure and compare how fair or unfair income distribution is in a society.
The following graph, comparing GDP per capita and income inequality in the UK, visualises the fact that economic growth is unlikely to decrease inequality. An increase in economic growth does not necessarily guarantee an equal distribution of benefits.
Income inequality rose significantly in the UK during the period of heavy period of unemployment in the UK, partially due to the mining closure which is also discussed here in the EF Hub. Despite the exponential rise in GDP per capita witnessed in the UK, income inequality has not decreased. Given this, many argue that GDP may be an inappropriate measure of living standards and that wider measures may be required for accurate conclusions to be drawn.
How does inequality in the United Kingdom compare globally?
Did you know? In the United Kingdom, those in the top 1% of households have 230 times more wealth than those in the bottom 10%!
