Readers Question: undertake an evaluation of what governments can learn from economic theory about raising their economies long-term growth rate?
The long-term growth rate depends upon the underlying trend rate of economic growth rate. This underlying trend rate of growth depends primarily on the growth of aggregate supply and productivity.
To increase the long term growth rate, Aggregate Demand plays a very limited role. In the Classical model of economic growth, an increase in AD would only cause inflation. However, you could argue that AD does have a role to play.
If an economy experiences a recession for a long time, the average long run growth rate will be lower. This is related to the theory of hysteresis. What has happened in the past is likely to happen in the future. Thus, if governments can manage aggregate demand, they can prevent recessions and help increase the average growth rate.
The neo-classical theory of economic growth suggests that increasing Capital leads to diminishing returns. Therefore, increasing capital has only a temporary and limited impact on increasing the economic growth. As capital increases the economy maintains its steady state rate of economic growth.
Basically, to increase the growth it is necessary to increase labour productivity, the size of the workforce or improve technology. In other words economic growth requires an increase in all aspects of growth.
This model was first suggested by Robert Solow over 45 years ago.
Adam Smith and Wealth of Nations
Adam Smith advocated laissez faire free markets. He argued that greater use of specialisation and division of labour could lead to higher growth rates. Criticised for ignoring market failure. Also free trade can be criticised for working against developing countries who struggle to diversify
New Economic Growth Theories (endogenous growth)
They place greater importance on the need for governments to actively encourage technological innovation. They argue in the free market classical view, firms may have no incentive to invest in new technologies because they will struggle to benefit in competitive markets.
- Place emphasis on increasing both capital and labour productivity.
- They argue that increasing labour productivity does not have diminishing returns, but, may have increasing returns
- They argue that increasing capital does not necessarily lead to diminishing returns as Solow predicts. They say it is more complicated, it depends on the type of capital investment.
- These theories associated with Paul Romer
Savings Ratio and Investment
Some growth theories place large emphasis on increasing domestic savings. Savings provide the necessary funds to finance investment. It is this investment which creates further growth. This has been an important factor behind the economic growth in Asia.
However, it depends on how efficient the investment is. If savings is too high it leads to lower growth because people cannot afford to consume.
Economic Growth for Developing Countries
Other theories have been suggested for developing countries. Amartya Sen and Joseph Stiglitz.
The Malthus Predictions
It is argued that economic growth may have limitations caused by lack of raw materials, climate change and overcrowding. Givern the failure of T.Malthus predictions to come true, these theories are often rubbished. Nevertheless, there may come a time when growth is constrained by environmental factors.