Can Governments Increase the Rate of Economic Growth?

Can Governments Increase the Rate of Economic Growth?

Governments often seek to increase the rate of economic growth. Higher growth rates improve public finances, increase economic welfare and help reduce unemployment. However, it is debatable how much the government can actually increase the rate of economic growth.

The greatest potential for increasing economic growth occurs when the economy is in a recession or period of sluggish growth. In this situation the economy experiences a lack of aggregate demand; there is spare capacity and output is less than potential (negative output gap)

In this case the government can pursue expansionary fiscal policy to try and boost the rate of AD. For example, the government could cut taxes and increase government spending. This leads to an increase in consumer spending (C) and (G). Expansionary fiscal policy will lead to higher government borrowing. However, in a recession, private sector saving usually rises and there is often greater demand for saving and buying bonds.

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In addition to government fiscal policy, in a recession, the Central Bank will be cutting interest rates in a recession to boost demand. This should also help increase AD.

Some economists argue that higher government borrowing and expansionary fiscal policy will be ineffective in boosting growth rates. This is because higher borrowing will cause crowding out. Because they buy more government bonds, the private sector will have less funds to spend on private investment. Also worries about the level of government debt may push up interest rates on bonds. These higher interest rates will reduce investment in the economy. For example, high rates of borrowing in Greece and Spain have pushed up interest rates on government bonds.

However, in a recession a rise in government borrowing doesn’t always cause a rise in interest rates. In Japan, UK and US, bond yields have remained low despite the rise in government borrowing. This is because in the current recession, there is greater demand for secure assets like government bonds. It is mainly countries in the Euro which have struggled to borrow.

The important thing is that governments can only boost AD if:

  • There is spare capacity in the economy
  • The private sector are willing to buy government bonds at low interest rates

If the economy is close to its long run trend rate, then expansionary fiscal policy will cause crowding out.

Supply Side Policies

In the long term, the government can try to increase growth rates through the use of supply side policies to increase productivity and efficiency. For example, policies of privatisation and deregulation can help increase efficiency. This enables an increase in productive capacity and shift AS to the right.

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Supply side policies can also be interventionist. For example, the use of education and training to increase labour productivity and efficiency. If successful, supply side policies can increase the long run trend rate of economic growth without inflationary pressure.

However, governments often over-estimate how much they are able to increase productivity growth. Most of the technological progress comes from private sector without government intervention. Supply side policies can help increase efficiency to some extent, but it is debatable how much they can actually increase growth rates.

For example, after supply side policies of 1980s, the government hoped there had been a supply side miracle which enables a much faster rate of economic growth. However, the Lawson boom of the 80s proved to be unsustainable and the UK growth rate remained pretty much the same at around 2.5% At the very least supply side policies will take substantial time, e.g. increasing labour productivity through education and training will take several years.

For developing economies with substantial infrastructure failures and lack of basic amenities, there is much greater scope for the government increasing growth rates.  By providing basic levels of education and infrastructure the scope for higher growth rates is much higher.

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