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ib economics hl notes
IB ECONOMICS HL

Consequences of Economic Growth

UPDATED ON - 24 SEP 2019

Learning Points:

  1.  Potential Impacts of Economic Growth on living standards

  2. Economic Growth and Unemployment

  3. Economic Growth and Inflation

  4. Economic Growth and The Distribution of Income

  5. The Current Account of the Balance of Payments

  6. Sustainability

Economic growth impacts many aspects of the economy, some negative, and some positive consequences.

Note that many of these consequences are not inevitable, but instead follow from the ways that growth is pursued.

Economic Growth and living standards

If the total GDP of a country increases faster than its population, then an increase in GDP per capita results. This indicates that there is a greater potential for people to increase their consumption of goods and services, and improve their standards of living.

 

However, GDP per capita is only an average measure and does not tell us how the increase in income is distributed or whether there is a broadly distributed improvement in living standards. HDI is a more appropriate measure of living standards.

 

Economic growth is associated with improvements in indicators measuring economic and human development. Major factors allowing economic growth to have positive effects on economic and human development include:

  • The distribution of income

    • The greater the income is going to poorer households, the greater the potential for contributing to human development, as the poorer households are those with the greatest deprivation in terms of education and health.

    • If increases in income made possible by economic growth bypass the poorer households, growth has limited effects on human development

  • Household spending on items that promote human development

    • The higher the share of household income spent on goods and services such as food, education, and healthcare, the higher the effect on human development.

  • The share of income controlled by women

    • The higher this is, the stronger the impact of human development – empowerment of women

  • Government spending on items that promote human development

    • The large the share of the government budget allocated to priority areas like education, healthcare, and infrastructure, including clean water supplies and sanitation, the higher the effects of growth on human development.

  • Contributions by non-governmental organizations (NGOs)

    • NGOs contribute to increasing the impact of growth on more development and higher standards of living.

  • Effectiveness of spending to promote human development

    • Depending on their level of development, different countries have different needs, which determine the effectiveness of spending to achieve human development

Economic Growth and unemployment

There is a distinction between economic growth due to the expansionary phase of the business cycle, and long‐term economic growth or increases in potential output. Economic growth due to the expansionary phase of the business cycle affects cyclical unemployment, which falls in expansion and increases in a contraction. If AG continues to increase beyond the full employment level of real GDP, leading to an inflationary gap, unemployment falls below the natural rate. However, this will only be temporary as government authorities are likely to step in with contractionary policies intended to close the inflationary gap and bring real GDP back towards its potential level with unemployment returning to the natural rate.

 

Therefore, economic growth due to the short‐term fluctuations of the business cycle can mainly reduce cyclical unemployment, but with only a temporary impact on natural unemployment. Sustained reductions in natural and structural unemployment may result from long‐term economic growth, involving increases in potential output (rightward shift of the LRAS or AS curves). Increases in potential output are caused by supply-side factors, such as increases in resource quantities, improvements in resource quality, technological changes, etc. However, not all increases in potential output lower natural unemployment – depends on the particular factors that cause the potential output to increase.

 

In certain situations, economic growth may lead to an increase in structural unemployment. This could occur when growth results from technological changes leading to a fall in demand for certain labour skills. Economic policies pursued by governments can either increase or decrease unemployment over the long term. Therefore, long‐term reductions in unemployment require economic growth, but not all economic growth results in lower unemployment.

 

While economics growth offers the potential to reduce unemployment, whether or not this will occur depends on particular factors and policies that lead to growth.

Economic Growth and Inflation

There is a distinction between economic growth due to the expansionary phase of the business cycle, and long‐term economic growth or increases in potential output.

The effects of growth on inflation depend partly on whether we use a monetarist/new classical or Keynesian approach.

Keynesian Model

In the expansionary phase of the business cycle, as real GDP increases due to increases in AG, the price level remains constant in the Keynesian model because of spare capacity and the presence of unemployed resources in the economy – this involves GDP increases along the horizontal part of the AS curve. However, as the real GDP approaches the level of potential output, resource bottlenecks begin to cause increases in resource and product prices, and continued AG increases beyond the level of potential output become highly inflationary.

Monetarist/New Classical Model

An increase in AG always causes an increase in the price level, even if the economy is initially in recession. In the long run, an increase in AD leads only to price level increases. Therefore, there is an agreement between both models that growth caused by increases in AG at about or beyond the level of potential output is inflationary.

 

Also, there is an agreement between both models that long-term economic growth, involving increases in potential output, works to reduce inflationary pressures. With increases in the productive capacity of the economy due to economic growth, growth in AG can be easily met without causing upward pressures on the price level.

Economic Growth and the distribution of income

There is no clear relationship between growth in GDP per capita and income distribution. Instead, what happens to income distribution as a country grows is a reflection of particular conditions in the country and the kinds of growth policies that are pursued.

 

For example, countries of East Asia placed a strong emphasis on the development of human capital, which ensured broad‐based participation in the benefits of growth, with positive effects on the equality of income distribution.

 

Yet, income inequalities in many countries have been widening over the past three decades. In both developed and developing countries, a major factor behind increasing income inequalities has been the growing use of market‐based supply-side policies. Transition economies have additionally been influenced by the switch to market economies and the loss of government protection of vulnerable groups.

 

In developing countries, income inequalities increased due to economic and trade liberalization (discussed earlier in CH17). While those who can take advantage of new opportunities gain, many become worse off, if they are less educated or skilled, cannot get credit, are geographically isolated, have nothing to produce for export, lose their jobs due to privatizations or reductions in the size of the government sector, etc.

 

In addition, income distribution in developing countries can worsen as a result of economic growth due to inappropriate government policies, such as:

  • The introduction of capital‐using technologies in industry and agriculture, creating unemployment

  • Low levels of government investment in human capital, which negatively affect people on lower incomes and poor disproportionately more than wealthier people

  • Allocating most services and infrastructure investments to urban areas and ignoring the rural sector where most of the poor life

  • Within the urban sector, concentrating infrastructure and services investments within the formal (modern and highly paid) sector and ignoring the urban slums.

 

It can, therefore, be concluded that economic growth is neither good nor bad for income distribution; this instead depends very much on the kinds of policies countries adopt in order to achieve growth.

Economic Growth and the Current Account of Balance of Payments

Short‐term economic growth, occurring over the business cycle, may lead to a larger current account deficit (or a smaller current account surplus). This is because increasing incomes lead to an increase in the demand for imports, and therefore a worsening balance of trade. If consumers’ marginal propensity to import is high, it indicates that a large fraction of an increase in incomes leaks out of the spending flow to purchase imports. Or when the demand for imports is income elastic.

 

However, when a country experiences long‐term economic growth, the trade balance is determined by factors that are likely to be unrelated to the rate of economic growth:

  • The international competitiveness of domestic industries

    • If domestic industries are efficient, low‐cost producers may have a competitive advantage over other countries, resulting in a higher level of exports, and therefore a smaller trade deficit (or larger trade surplus) even as the economy grows.

  • Exchange rates

    • If the country’s exchange rate is weak or undervalued, it creates an artificial competitive advantage, resulting in more exports and fewer imports, working to reduce the size of a trade deficit, even as the economy may be growing.

  • The degree of export orientation of the Economic economy

    • Economic growth that depends heavily on increases in exports may result in strong trade surpluses even as incomes increase.

  • Growth of incomes of trading partners

    • If incomes abroad are growing rapidly and for extended periods, there will likely be increases in exports, even as the country itself is growing.

  • The degree of protectionist trade policies faced by exports

    • If a country’s exports do not face trade barriers in other countries, they may be able to increase its exports (assuming it is an efficient producer) even as its economy grows.

 

Therefore, while economic growth may lead to a larger deficit or smaller surplus in the upward phase of the business cycle, over the long term, there is unlikely to be a clear relationship.

Economic Growth and Sustainability

Economic growth and environmental sustainability are conflicting objectives ‐ Experience shows that growth often leads to unsustainable resource use. E.g., very high growth rates in East Asian countries have been associated with serious environmental losses such as high levels of air pollution, soil degradation due to soil erosion, waterlogging and overgrazing, threats to biodiversity and deforestation, etc.

This may be due to:

  • Industrialization based on fossil fuels

  • Increasing incomes lead to consumption patterns based on greater fossil fuel consumption (e.g., use of cars, air conditioners, etc.)

  • Commercial logging and agricultural processes based on a lack of pricing mechanism for common access resources result in their unsustainable use.

Many governments follow the belief ‘grow now, clean up later.’

Problems with this way of thinking:

  • Some environmental damage is irreversible

  • It justifies government inaction on the environment.

  • It is not growth itself that is bad for the environment, but rather the ways that growth is pursued.

  • It is not growth itself that is bad for the environment, but rather the ways that growth is pursued – if growth was pursued differently, it need not conflict with environmental sustainability.

  • Growth based on unsustainable resource use may lead to the destruction of natural resources on such a wide scale that the possibility of continued future growth may be threatened.

Economic growth and environmental sustainability can be successfully pursued together under certain conditions:

  • Governments implement market‐based policies that ‘internalize the externalities’ – correcting them and providing incentives for sustainable resource use and promotion of green technologies

  • Governments pursue environmental regulation that encourages pollution‐free technological change

  • An increased emphasis on human capital in production as opposed to physical capital

  • An increased emphasis on ‘green’ investments, which promote growth while not hurting the environment. (E.g. building public transportation systems, investing in insulation in homes and buildings, investing in clean technology R&D)

  • Changes in the structure of the economy toward more services together with more investments in the protection of natural resources.

However, modern growth theories show that there is a maximum rate of growth that is consistent with environmental sustainability, and that if an economy exceeds this rate, resource use will become unsustainable (only applies to very high rates of growth).

 

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