Why is economic growth important and what propels it?
A
country’s growth and level of national income, measured by real gross domestic
product (GDP), is used as an indicator of development. A higher GDP is
correlated with low crime rates, higher life expectancy, and general good health,
higher education levels, less poverty, low levels of conflicts and a higher
public service delivery, among others. Improvements in the level of GDP become
central to improving the well-being of the society. Before going into the
drivers of GDP, let’s briefly examine its components first.
National
income captured by GDP has four components which are personal consumption, investment,
government spending and net exports (exports minus imports). Each of these
components plays a crucial role in determining the growth in GDP and subsequently
the economy. An increase in autonomous consumption stimulates the economy in a
ripple manner that causes income to increase by a significantly greater
proportion than the initial increase in consumption. Investment increases the
country’s productive capacity leading to an increase in income via production.
Government consumption/purchases increases GDP through the multiplier effect where
a smaller proportion of spending results in significant increases in income.
For simplicity, we just assume that the government is forward looking and thus engages
in productive spending which positively contributes to economic growth. In later
posts, we will relax this assumption and discuss the implications to national
income in the instance when the government lacks that foresight. Lastly, exports inject income into the economy
while imports act as a leakage of income. As a country grows, it generally spends
more on investment and at later stages it re-balances by leaning heavily on
private consumption.
Another
important avenue to increasing national income is through increasing
productivity. Productivity – generated
through what’s called an aggregate production function is the process whereby
an economy as a whole turns economic inputs into output measured as GDP. The
components of a production function are human capital, workforce, physical capital,
and technology. Human capital the accumulated skills and education of workers
and increases output per worker. Workforce is the total number of people in a
country or region who are physically able to do a job and are available for work
and the higher the number the higher is output. Physical capital consists of
man-made goods such as machinery, computers, and other equipment that are needed
for the production of goods and services. A higher investment in physical
capital increases labour productivity. Lastly, technical knowledge refers to
society’s understanding about how the world works, hence, how goods can be
produced in the best way possible by combining all the production inputs.
Constantly, acquiring new technology increases the ability to produce more output
per each resource a country has.
Another major thing that also influences economic growth in developing countries is the
quality of governance as measured by the following six components: (1) Government
effectiveness - measures the perceptions of the quality of public services,
civil service and the extent of their independence from political pressures,
the quality of policy formulation and implementation, and the credibility of
the government’s commitment to such policy strategies. , regulatory quality,
voice and accountability, political stability, control of corruption, and the
rule of law; (2) Regulatory quality – captures the perceptions of the ability
of the government to formulate and implement sound policies and regulations to
promote private sector development; (3) Rule of law – encompasses the extent to
which economic agents abide by societal rules and trust the government including
contract enforcement, property rights, police, judicial system and the
likelihood of crime and violence; (4) Voice and accountability – captures the
views and extent to which economic agents partake in electing their own
government, are free to express themselves, and have free access to the media; (5)
Political stability – measures the degree to which a country is susceptible to
the likelihood of politically-motivated violence including terrorism; and (6) Control of
corruption – captures the perceptions of the extent to which public power is
exercised for private gain including petty and larger forms of corruption. It’s
important to note that the failure of any one or all of the governance indicators
will contribute to market failure or inefficiency which will inevitably have a negative
impact on the country’s economic growth.
