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Economic Growth and Fluctuation

Introduction

Economic growth has been a major concern for various economists over time. This is due to the fact that it relates to the long welfare of a country. According to Robert (1999, 1), economic growth is referred to the process through which the wealth of a country increases over a given period of time. The rate of economic growth indicates an increase or reduction in the economic activities of a country. The Gross Domestic Product (GDP) is used to determine economic growth of a country (Eurostat 2007, 1). To effectively determine economic growth, the current rate of inflation is factored in the Gross Domestic Product to give the real GDP. Economic growth of a country has an impact on the citizen’s standards of living, output levels in relation to goods and services and the income level (Robert 1999, 2). Therefore, if the economic growth is high, the quality of living tends to be high. This is due to the fact that there will be an increase in the per capita income as GDP increases. Various factors influence the rate of economic growth of a country. These factors include land, labor, capital and entrepreneurship. Three main economic growth theories have been of great concern amongst economists. These include the classical theory, neoclassical and new growth theory. Various models have been formulated in relation to these theories. The classical theory relates to economic researches that were conducted in the eighteenth century by economists such as Adam Smith, Thomas Robert and David Ricardo. On the other hand neoclassical theory was advanced by economists such as Robert Maslow. Neoclassical theory of growth is concerned with the ease through which capital and labor as factors of production can be substituted to stimulate a steady rate of economic growth. Through the Solow’s Neoclassical growth model, capital and labor as factors of production are regarded as substitutable (Dwight, Steven & David 2006,.3). The process of substitution ensures that the other economic variables are undergoing a constant and proportional rate of growth. With regard to neoclassical growth models, economic growth is associated with technology and population increase. On the other hand, the accumulation of capital determines the ratio of capital to labor in a steady state (John 1962, 3). The discussion of this paper is aimed at illustrating the process through which growth theory explains the long run behavior of an economy.

Long run in Macroeconomics

In macroeconomics, long run refers to a period of time when all the factors of production become variable. In the long run, more emphasis is on the process through which the economic productivity of a country increases over time (Peter M, 6). This means in relation to growth theory, the potential GDP is considered.

There are two main parts in the analysis of the long run. The first part involves determining a country’s steady state and capital to output ratio (Herman 1991, 1). The second part involves the determination of the rate of innovation and invention within the economy. In the long run, an economy that is characterized by a high rate of capital to output ratio and a correspondingly high rate of innovation will experience a high rate of economic growth. On the other hand an economy whose rate of invention is high and also has a high rate of growth in productivity experiences economic growth at a faster rate in the long run.

In order to stimulate the rate of economic growth, one of the methods that can be incorporated includes increasing the amount of capital stock. For example, the most common way of increasing capital stock of a country of a country in the long run is through increasing the size of investment. This results into an increase in capital stock for every worker. As more workers are able to access capital, their productivity increases resulting into economic growth.

Principles of neoclassical growth models

Capital accumulation as a determinant of growth

Neoclassical theory of growth asserts that economic growth of a country depends on the amount of capital accumulated (Reiner, Peter, and Alpo 2007, 4). This means that it is possible to increase the rate of economic growth by increasing the amount of capital. In this context, capital refers to the various resources that are combined to enable the effective production of goods and services. In relation to capital accumulation, human capital is one of the most important factors of production that increase the rate of economic growth of a country. The contribution of human capital to economic growth can either be direct or indirect. According Maria (2001, 7), human capital can contribute to economic growth in two main ways. Through education, human labor is enhanced enabling it to contribute directly to the production process. This means that the accumulating human capital will result into an increase in the level of output. This is referred to as the level effect (Maria 2001).

Alternatively, accumulation of human capital can increase the rate of technological innovation. This is due to the fact that education increases efficiency in technological innovation. It also becomes easy to integrate new technology within the economy. This shows that the size of human capital has an effect in relation to growth of productivity. In neoclassical theory of growth, this is referred to as the rate effect (Maria 2001, 8). Therefore the concept of capital accumulation asserts that it is possible for a country to increase the productivity of the citizens by increasing the size of the capital.

Relationship between capital, technology and output

According to neoclassical growth model, growth in the level of output is directly related to growth in the size of labor, capital and technological growth. The direct relationship means that growth in either of the factors of production (capital and labor) will result into a proportionate growth in the size of output. In neoclassical growth model, technology is considered to be an important element in relation to economic growth. On the other hand, it is considered to be exogenous. This means that it cannot be affected by changes related to capital and labor. For example, an increase in the size of capital will have no impact to progress in technology. On the other hand, there is an assumption that there is a positive correlation between technology and the level of output. This means that through advanced technology, the efficiency of productivity of labor and capital is increased. This results into an increase in the size of economic output.

Net investment

Net investment in relation to economics refers to net increase the size of capital. It is represented by the difference between gross investment and capital consumption. Neoclassical growth model asserts that an increase in net investment of a country results into an increase in economic growth rate. This results into maintenance of the countries economic steady state in the long run (Steve, Asli & Fabio, 2004, p.1).

For economic growth to be sustained, neoclassical theory of growth asserts that it is paramount for there to be enough savings. In order to increase the level of savings, this theory contends that consumption should be postponed. Through an increase in the amount of savings, it becomes cost effective for the country to raise the required investment finance. This makes it possible to allocate finances to various investments (Ramsey 1999, 2).

The graph below illustrates the Solow model of neoclassical growth

Basic solow growth model diagram
Source: Economics of development: theories of growth

From the figure, the production function is represented by the curve Y=f (K, L). The curve is U-shaped depicting the ease of substitution between capital K, and labor, L. The curve Sy represents the savings function. The curve (n+d) represents the rate of capital consumption. Point A depicts the point at which new savings will be equal to the amount of capital needed to for there to be growth in labor force and cater for depreciation. This point also the steady state where economic equilibrium occurs. At this point the level of output increases as the size of labor increases. However, at this point the GDP is constant. As the saving rate increases, there is a corresponding increase in the size of capital from K1 to K2. Therefore through an increase in the rate of savings, the size of capital is also increased. This means that the increase in capital will be able to cater for the growth in labor force (Dwight et al 2006, 12).

Analysis of United States of America economic performance

In the recent decades, the US economy has experienced a rampant rate of economic growth. According to Tim (2004, 1), there was a 3.7% growth in the economy in real terms. This was a high rate of economic growth considering the fact that US rate of economic growth has been 3.2% since 1970. The high rate of economic growth resulted from US government implementing effective policies in relation to investment. There was an increase in investment in relation to information technology.

Tim (2004) asserts that there has been an increase in the average investment rate from a low of 5.9% in the 1970’s to a high of 14.7% in 2003 after the implementation of the tax cut policy. It is estimated that the annual increase in the level of investment amounts to $ 770 billion.

In comparison with Japan and other countries of the euro region, the American standards of living were high from 1999 to year 2004 compared to Japan and other countries of Euro. The high standard of living resulted from the increase in economic growth due to increased investment in technology. This is depicted by the high rate of GDP. There was a decline level of US GDP during 2001.

cross country real gdp growth comparison
Source: Past, present and future: economic growth in America

The table below illustrates the economic growth of various developed countries over a period of 1999-2004.

Country Share of capital Growth in GDP Growth from increase in capital Growth from labor
US 40 4.02 1.71 0.95
Germany 39 6.61 2.69 0.18
Japan 39 9.51 3.28 2.21
UK 38 3.73 1.76 0.03

Source: Focus on economic data: US real GDP growth.

The table illustrates a Japan having a high rate of growth in GDP at 9.51. This is due to the fact that the country experienced a high rate of growth in relation to capital and labor force (3.28 and 2.21 respectively). US also had a higher growth in GDP at 4.02. This growth is associated with a high rate of growth in capital and labor.

Conclusion

Economic growth is an important element for every country. Through economic growth, the level of an economy’s Gross Domestic Product is increased. Increase in the GDP results in an increase in the per capita income. This results in an improvement in the living standards of the citizens. The rate of economic growth of a country is influenced by the factors of productions which include land, capital, labor and entrepreneurship.

Economic growth of a county is experienced in the long run where all the factors of production are variable (Mankiw 2006, 12). Through the long run, there is creation of synergistic effect amongst the various factors of production. This is due to the fact that there is a direct relationship between labor and capital as factors of production. This means that an increase in one of the factors of production results into an increase in the amount of output. Various theories of growth have been advanced by different economists to explain the rate of economic growth. These include the classical, neoclassical and the new growth theory. Neoclassical theory asserts that labor and capital can be substituted to enhance the rate of economic growth. The neoclassical theory of growth contends that economic growth can be achieved through three main ways which include capital accumulation, growth in labor force and technological progress. Capital accumulation involves improving the quality of human capital through education. This would result in effective and efficient labor force. Technological progress also results in an increase in the rate of growth. Economic growth also results from an increase in the size of net investment. The level of investment in an economy is influenced by the rate of savings within a particular country.

Reference List

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