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AP®︎/College Macroeconomics
Course: AP®︎/College Macroeconomics > Unit 5
Lesson 7: Public policy and economic growthLesson summary: Public policy and economic growth
In this lesson summary review and remind yourself of the key terms and concepts related to how policymakers can influence economic growth.
Two hundred years ago, there wasn’t much difference between countries in terms of national income and standard of living. As described by the statistician Hans Rosling, “all countries were sick and poor.”
We can visualize this in the graphs shown below. Each graph shows the distribution of health, as measured by life expectancy, and wealth, as measured by real GDP per capita. Each dot represents a country. Note that all countries in 1818 have low levels of wealth and health, and are tightly packed together. But the 2018 graph tells a different story entirely: 200 years of unequal economic growth has lead to wide differences between countries in both wealth and health.
So, why were growth rates different between countries? In this lesson, we explored the sources of economic growth.
Key Terms
| Key Term | Definition |
|---|---|
| infrastructure | the underlying structure within an economy that facilitates economic activity, such as roads, bridges, railroads, and critical internet structures |
| research development (“R&D”) | spending by firms to create new technologies and to put those new technologies to work |
| localization of knowledge spillovers | the concept that ideas spread more easily over short distances; because R&D may occur more rapidly in places where many people are working on it at the same time, such as cities. |
| Institutions | in the context of growth, these are the preconditions that must exist for growth to occur, such as political stability, secure property rights, and government intervention that is excessive |
| supply-side fiscal policies | fiscal policies that promote incentives to save and invest as engines of growth, such as reducing taxes on businesses |
| productivity | a measure of the output per person in an economy, such as real GDP per capita |
| depreciation rate | the rate at which capital wears down; for example, if capital depreciates 10% each year, 10% of that capital must be replaced each year to maintain the same sized capital stock. |
Key takeaways
Economic growth depends in part on policies that affect productivity and the labor supply
Output per person grows when output increases faster than increases in population. That means anything that positively impacts productivity leads to higher rates of economic growth. A government policy that encourages the accumulation of the four economic resources increases output and the rate of growth.
Examples of policies that affect productivity are:
Encouraging labor force participation: By increasing the share of the population that are workers, you increase the quantity of labor available.
Investing in human capital - By increasing the health and education of workers, those workers are more effective and can produce more. Improving human capital increases the quality of labor available.
Policies that increase infrastructure and technology affect economic growth
Technological progress comes largely from initiatives in the private sector, but governments also play an important role in encouraging research and development. For example, government policies that protect intellectual property, such as patents, give private firms more incentive to create that intellectual property.
Additionally, governments are frequently the creators of technology themselves. For example, many countries have government agencies that engage in creating original science and research and development that directly benefits the private sector.
Governments also play a key role in developing a country’s infrastructure. Good, dependable transportation systems help businesses get inputs to production, and get goods to customers. That means that not only does government spending on infrastructure raises government spending and real GDP, but also contributes to the growth of real GDP in the long run.
Supply-side fiscal policies affect all three of the curves in the AD-AS model
Proponents of supply-side policies focus their attention on government policies that may block short-run or long-run aggregate supply from increasing. For example, if business taxes are too high, it increases the cost of operating which lowers short-run aggregate supply. Similarly, a decrease in income taxes should lead to more disposable income for households, allowing households to supply more savings in the market for loanable funds.
According to this theory, either of these actions leads to more investment. More savings make the amount of investment in capital cheaper. The investment in capital increases aggregate demand (AD) through its effect on the investment component of AD. The increase in the stock of capital increases both the long run aggregate supply and the short-run aggregate supply curves.
Common misperceptions
New learners frequently struggle with whether policies that impact economic growth are associated with aggregate demand or aggregate supply. Policies that act primarily on aggregate demand are usually the result of attempts to affect the investment category of real GDP. If those policies also happen to lead to more accumulation of resources, such as capital, then they also lead to economic growth. Supply-side policies are usually related to changing savings rates or investment demand, such as investment tax credits.
Questions for review
Business optimism has increased the demand for loanable funds.
(a)Why would more optimism by firms increase the demand for loanable funds?
(b)Show the impact of the increase in the demand for loanable funds on the interest rate using a correctly labeled graph of the loanable funds market.
(c)What happens to economic growth as a result of the increase in the demand for loanable funds? Explain.
Want to join the conversation?
So what is the answer to (c)?(6 votes)
Because there is more demand for loanable funds, businesses are eager to borrow money to invest in new capital. This increases the capital stock of an economy and causes economic growth, shifting the PPC out.(0 votes)