Lesson summary: Public policy and 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.

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.

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.

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.

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.

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.