Growth and Development

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Macro Economics and Buisenss Environment

Growth and Development

By: Dr. Neelam Tandon

Over the years, economists from different schools of thought have had plenty to say on what
really drives economic growth for an economy. In this chapter we review some of these ideas.
In particular we consider the importance of supply-side factors in determining the trend rate
of growth for countries competing in the global economy.

Trend growth
Economic growth is best defined as a long-term expansion of the productive potential of the
economy.

Trend economic growth refers to the smooth path of long run national output. Measuring the
trend rate of growth requires a long-run series of macroeconomic data (perhaps of 20 years or
more) in order to identify the different stages of the economic cycle and then calculate average
growth rates from peak to peak or trough to trough. Another way of thinking about the trend
growth rate is to view it as an underlying speed limit for the economy. In other words, it is an
estimate of how fast the economy can reasonably be expected to grow over a number of years
without creating an unsustainable increase in inflationary pressure.

INDIA GDP GROWTH RATE

The Gross Domestic Product (GDP) in India expanded at an annual rate of 8.80 percent in the
last reported quarter. From 2004 until 2010, India's average quarterly GDP Growth was 8.37
percent reaching an historical high of 10.10 percent in September of 2006 and a record low of
5.50 percent in December of 2004. India's diverse economy encompasses traditional village
farming, modern agriculture, handicrafts, a wide range of modern industries, and a multitude of
services. Services are the major source of economic growth, accounting for more than half of
India's output with less than one third of its labor force. The economy has posted an average
growth rate of more than 7% in the decade since 1997, reducing poverty by about 10 percentage

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points. This page includes: India GDP Growth Rate chart, historical data and news.

Year Mar Jun Sep Dec


2010 8.60 8.80
2009 5.80 6.00 8.60 6.50
2008 8.50 7.80 7.50 6.10

India's economy expanded 8.8% in the second quarter from a year earlier, compared to an 8.6%
on-year expansion in the first, lifted by robust activity in manufacturing.

Agricultural output along with strong development in the Industrial and Mining sector has
helped to boost the Indian economy. Agricultural output rose 2.8 per cent y-o-y thanks to
improved harvests. Industrial production increased by 12% and in the mining sector by 9%.

However, in spite of strong supply data, private consumption slumped to 0.3% y-o-y in Q2 from
2.6% in Q1, fixed investment has dropped to 3.7% from 17.7%, government consumption

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growth was negative and both export and import growth contracted.

The Reserve Bank Of India has stated that it had seen an annual growth of 8.5% steadily. The
main priority of the Reserve Bank is to curb the ongoing inflation, which peaked at 11% last
month. Interest rates have been increased by the banks to contain the inflation, but it could slow
down the growth of the Indian economy in the coming months. But even thought there has been
a rise in the interest rates there hasn’t been much change in the distribution of loans, the Indian
customer is hardly affected with the hiked interest rates.

To reduce Inflation hike it is requried to take following measures:

1. Raise capital investment spending as a share of national income.


2. Achieve higher productivity from both capital inputs and from our labour supply.
3. Expand the size of the labour supply, perhaps through an increase in the migration of
high productivity workers.
4. Increase the level of research and development and increase the pace and application
of innovationacross the economy.

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The effects of an increase in long run aggregate supply are traced in the diagram below. An
increase in LRAS allows the economy to operate at a higher level of aggregate demand – leading
to sustained increases in real national output.

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Government policies to improve the trend growth rate
Over the last twenty years, government of different political persuasions, have put in place
policies which they expect will be successful in raising investment, encouraging
entrepreneurship and improving incentives to work. Potential output in the long run depends on
the following factors

(1) The growth of the labour force


If the government can increase the number of people willing and able to seek paid work, then the
employment rate increases leading to a higher output of goods and services. The Government
has relied on a number of job schemes designed to raise employment including Jawahar Rojgar
Yojna, Self Employment Gauarantee Programme and many more. Changes in the age structure
of the population also affect the total number of people seeking work. And we might also
consider the effects that migration of workers into the UK from overseas, including the newly
enlarged European Union, can have on the UK’s labour supply.

(2) The growth of the nation’s stock of capital


A rise in capital investment adds directly to GDP in the sense that capital goods have to be
designed, produced, marketed and delivered. Higher investment also provides workers with more

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capital to work with. New capital also tends to embody technological improvements which
providing workers have sufficient skills and training to make full and efficient use of their new
capital inputs, should lead to a higher level of productivity after a time lag.

(3) The trend rate of growth of productivity of labour and capital.


For most countries it is the growth of productivity that drives the long-term growth. The root
causes of improved efficiency come from making markets more competitive and achieving
better productivity within individual plants and factories. Increased investment in the human
capital of the workforce is widely seen as essential if India has to improve its long run
productivity performance – for example – increased spending on work-related training and
improvement in the Indian education system at all levels.

(4) Technological improvements


Changes in technology are important because they reduce the real costs of supplying goods and
services which leads to an outward shift in a country’s production possibility frontier

Economic growth and causation – different schools of thought


For many years, economists have been discussing the causes of growth and development. There
is little sign of a consensus emerging! Here are some of the main lines of thought.

Neo-Classical Growth
The “neo-classical” model of growth was first devised by Nobel Prize winning
Economist Robert Solow over 40 years ago. The Solow model believes that a sustained increase
in capital investment increases the growth rate only temporarily: because the ratio of capital to
labour goes up (i.e. there is more capital available for each worker to use). However, the
marginal product of additional units of capital is assumed to decline and thus an economy
eventually moves back to a long-term growth path, with real GDP growing at the same rate as
the growth of the workforce plus a factor to reflect improving productivity.

A ‘steady-state growth path’ is eventually reached when output, capital and labour are all
growing at the same rate, so output per worker and capital per worker are constant.
Neo-classical economists who subscribe to the Solow model believe that to raise an economy's
long term trend rate of growth requires an increase in the labour supply and also a higher level

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of productivity of labour and capital.

It is worth to note that this theory is appropriate for developed countries but not country
like India which needs huge investment to grow.

Differences in the rate of technological change between countries are said to explain much of the
variation in growth rates that we see. The neo-classical model treats productivity improvements
as an ‘exogenous’ variable, meaning that productivity improvements are assumed to be
independent of the amount of capital investment.

The significance of productivity as a source of supply-side performance and as a contributor to


long-term growth is now widely accepted by many economists. A recent analysis of the long
term prospects for India from the International Monetary Fund argued that the main challenge for
the country in the years ahead is to improve factor productivity since there remains a
sizeable productivity gap between India and many of our major international competitors.

Endogenous Growth Theory

Endogenous growth economists believe that improvements in productivity can be linked


directly to a faster pace of innovation and extra investment in human capital. They stress
the need for government and private sector institutions which successfully nurture innovation,
and provide the right incentives for individuals and businesses to be inventive. There is also a
central role for the accumulation of knowledgeas a determinant of growth. We know for
example that the knowledge industries (typically they are in telecommunications, electronics,
software or biotechnology) are becoming increasingly important in many developed countries.

Supporters of endogenous growth theory believe that there are positive externalities to be
exploited from the development of a high valued-added knowledge economy which is able to
develop and maintain a competitive advantage in fast-growth industries within the global
economy.

The main points of the endogenous growth theory are as follows:

• The rate of technological progress should not be taken as a constant in a growth model –

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government policies can permanently raise a country’s growth rate if they lead to more
intense competition in markets and help to stimulate product and process innovation.
• There are increasing returns to scale from new capital investment. The assumption of the
law of diminishing returns which forms the basis of so much textbook economics is
questionable. Endogenous growth theorists are strong believers in the potential for
economies of scale (or increasing returns to scale) to be experienced in nearly every
industry and market.
• Private sector investment in research & development is a key source of technical
progress.
• The protection of private property rights and patents is essential in providing appropriate
and effective incentives for businesses and entrepreneurs to engage in research and
development
• Investment in human capital (including the quantity and quality of education and training
made available to the workforce) is an essential ingredient of long-term growth. This is
discussed next.
• Government policy should encourage entrepreneurship as a means of creating new
businesses and ultimately as an important source of new jobs, investment and innovation.

The Importance of Human Capital


The basis of human capital lies in the theories of the Theodore Schultz, an economist at the
University of Chicago who was awarded the Nobel Prize for Economics in 1979. Schultz, an
agricultural economist, produced his ideas of human capital as a way of explaining the
advantages of investing in education to improve agricultural output. Schultz demonstrated that
the social rate of return on investment in human capital in the US economy was larger than
that based on physical capital such as new plant and machinery.

Gary Becker, the 1992 Nobel Prize winner for economics, built on the ideas first put forward by
Schultz, explaining that expenditure on education, training and medical care could all be
considered as investment in human capital. He wrote that “people cannot be separated from
their knowledge, skills, health or values in the way they can be separated from their financial

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and physical assets."

Innovation
Innovation is the creation of new intellectual assets. We can make a useful distinction between:

Process innovation: This relates to improvements in production processes, the more efficient
use of scarce resources to produce a given quantity of output - leading to improvements in
productive and technological efficiency

Product innovation: This is the emergence of new products which better satisfy our ever-
increasing needs and wants - leading to improvements in the dynamic efficiency of markets in
providing goods and services
Indeed, it is often the ‘drive to innovate’ which is the primary motive for capital investment in
the first place, not least in international markets where a firm's competitive edge is determined by
the success of strategies designed to find viable innovations that give it what is often called ‘first
mover advantage in a market’. Innovation in the pharmaceutical industry; in
telecommunications; in household goods and in biotechnology is good examples of sectors
where successful innovation is the key to maintaining a competitive advantage.

In short - successful innovation is a stimulus to long-run growth because:

• It acts as a catalyst for higher rates of investment in fixed capital and increased
investment in human capital which helps to shift out the production possibility frontier
• It can act as a spur to faster productivity growth (with time lags) because of its impact on
technological progress
• Innovation also creates a demand for new products from consumers for example in
industries where existing products are nearing the end of their product life-cycle

Social benefits from innovation


There are potentially huge positive externalities from technology spill-over effects arising from
innovation for example in the pharmaceutical industry where new drugs improve the quality of
life and increase life expectancy and also improvements in car manufacture and design that

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reduce the risk of serious injury from road accidents.

Inter-firm collaboration in the creation and use of innovations can also act as a key contributor
to industry-wide growth leading to external economies of scale. Indeed this form of co-
operative behaviour between businesses is judged to be legal by the European competition
authorities whereas price fixing and other forms of anti-competitive behaviour is now the subject
of frequent investigations and legal action.

The US economist William Baumol in his recent book “The Free-Market Innovation
Machine” stresses that firm’s use innovation as a ‘prime competitive weapon’. However, firms
do not wish to risk too much innovation, because it is costly, and can be made obsolete by rival
innovation. So, firms have responded to this through the sale of technology licenses and
participation in technology-sharing compacts with other firms that can pay huge dividends to
the economy as a whole. According to Baumol, innovative activity becomes mandatory, in his
words, ‘a life-and-death matter for the firm.’

Social capital and economic growth

We have seen that investment in physical capital and human capital are both regarded as
important sources of long term growth for modern countries competing in the global economy.
There is also increasing interest in a concept known as social capital – if you like, a third strand
in the idea that capital promotes growth.

Social capital focuses on the value of social networks in improving productivity in an economy.
According to the author Robert Putnam in a book entitled “Bowling Alone”, “it refers to the
collective value of all social networks and the inclinations that arise from these networks to do
things for each other"? So, social capital cites the interrelationships between individuals as a
major driver of growth.

Putnam talks about “bonding” and “bridging” social capital, with the latter as the one which
enhances productivity. This is the idea that social groups bridge from one to another through
shared interests, such as ten-pin bowling.

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This creates an atmosphere of trust and friendliness between people, which has numerous
benefits for society as whole, which some would term as positive externalities. For example, a
sense of “togetherness” among the bowling fraternity will indeed increase the growth of the
bowling sector of the economy, since more meetings will require more money to be spent on
hiring bowling alleys and buying all the other ingredients for a great night’s bowling. However,
the atmosphere of trust and friendliness created may also allow people to be more amiable to the
idea of sharing lifts to and from meetings, thus lowering car pollution. A trivial example it may
be, but it suffices to show how social capital can have an impact on the society as a whole.

“Bonded” social capital, on the other hand, creates exclusivity. Groups, such as gangs, are based
on hierarchical patronage rather than meritocratic methods, potentially meaning that productivity
falls. However, in both these examples social capital is being used for advantage. The problem
with the latter is that this advantage is for a number of individuals rather than for collective
society.Social networks can be used to spread beneficial ideas, causing individuals and society to
simultaneously progress. An example of this would be, in times of low savings (which could
potentially cause a pensions crisis in the future), social networks spreading the “acceptability of
saving, and thus benefiting the economy.

Key Points
Economic growth is a long-run increase in the capacity of the economy to produce goods and
services, and can be illustrated by an outward shift in the production possibility frontier.

• Trend growth is the long term non-inflationary increase in output (GDP) caused by an
increase in productive capacity i.e. LRAS.
• Growth occurs because of an increase in the quantity and/or quality of factor resources.
Human capital is the skill and knowledge level of the workforce, as well as their health.
The higher the quality of human capital, the higher the productivity as workers adapt
more effectively to new technologies and learns to perfect their respective specialised
jobs. Actual skill levels, as opposed to educational qualifications, are now seen as
powerful drivers of economic growth.
• Social capital represents the networks and shared values which lead to greater social co-

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operation and mutual trust .

• Innovation is a major determinant of growth. It helps to lower costs and it also creates
new markets, a source of demand, revenue and profits for businesses in the domestic and
the international economy.

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