Can A Government Increase the Rate of Economic Growth

By: Richard Pettinger
Submitted: 2007-01-17 16:25:25
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The rate of economic growth measures the annual % increase in Real GDP. The long term trend rate of economic growth in the UK is about 2.5%. TO increase this the govt will have to use supply side policies. However there may be instances when increased AD will also be able to increase the rate of economic growth.

If the economy is below full employment and there is spare capacity within the economy. The govt can use demand side policies to increase the rate of economic growth. For example the govt could use fiscal policy to increase the rate of AD. This could involve cutting taxes and increasing the level of govt spending.

AD= C+I+G+X-M. Therefore higher Government spending will increase AD and lower taxes will increase disposable income thereby increasing Consumption and AD.

Also the MPC could cut interest rates. This reduces the cost of borrowing and reduces monthly mortgage payments. Therefore there will be an increase in the level of borrowing, consumption and investment.

However demand side policies do have some problems, firstly there will be time lags between changing taxes or interest rates and having an effect on AD. Also if consumer confidence is lower interest rates may not have much effect on increasing consumption. Also increasing AD can conflict with the govt objective of low inflation. If the economy is close to full capacity higher AD will cause inflation.

Classical economists argues that higher AD will always cause inflation, because the Long Run Aggregate Supply curve is inelastic.

In the classical model an increase in AD causes higher output in the short run, however as inflation increases, wages and therefore the costs of firms increase causing the SRAS to shift to the left. Therefore the economy returns to the level of Full employment but with higher inflation. Therefore classical economists argue that demand should not be used to increase the rate of economic growth.

However this classical model is not necessarily correct. Keynesians argue that an economy can be in a recession for a long time. This is because of low consumer confidence reducing spending and the negative multiplier effect reducing further the initial fall in AD. Therefore in a recession Keynesians would argue that it is important to increase AD even if a re-flationary fiscal policy causes a budget deficit.

Nevertheless both Keynesian and classical economists argue that to increase the long run trend rate of economic growth it is necessary to increase productivity and shift the LRAS to the right this can be done through supply side policies.

For example the govt can increase the incentive to work by cutting taxes and reducing benefits. However there is no guarantee that lower taxes do increase work incentives. The Income effect means people can work less to earn the same amount of money. Also inequality may increase.

The govt can overcome market failure by increasing spending on education and training, this will increase labour productivity and therefore efficiency in the economy. However this policy will take time to have effect. Also govt intervention may not be very successful because of poor information leading to subsidising of the wrong types of training.

A third type of supply side policy could be to follow a programme of privatisation and deregulation. Privatisation involves selling govt owned industries to the private sector. The advantage of this is that the private sector has a profit incentive to increase efficiency. However there are dangers that a private monopoly may exploit consumers. The example of rail privatisation also showed that privatisation may not be successful, private firms under invested in the network because they took the short term view.

Deregulation involves increasing competition in an industry this has obvious benefits of lower prices and better quality but is difficult to achieve in industries such as rail and water.

Supply side policies may help improve productivity in the long term, there is evidence that since the govts many supply side policies introduced in the 1980s the economy has performed better with inflation remaining low despite growth being strong. However there is a limit to how much the govt can increase productivity many issues are beyond their control, for example it is difficult for the govt to improve technology and working ethics. Also the rate of economic growth is likely to be effected by global events over which the UK govt has no control.

Article source: Expert Articles