Thursday, 25 October 2012
So with UK returning to growth today (yay) I thought I would post this slightly more serious/technical article on the nature of economic growth and why some countries experience more growth then others. Any questions comment below....
Promoting economic growth is a major concern due to the fact that high economic growth is generally associated with rising living standards. In the world today approximately 3 billion people, are said to live on less than $2.50 a day and more than 80% of the world’s population lives in a country where income differentials are rising. Although it's true that physical capital does influence the growth rate of a country, you must not ignore human and knowledge capital as well as an appreciation of the political and international context of a country in order to fully explain the difference in growth rates.
Conditional convergence states that an economy’s growth rate is greater the further away it is from its "steady state" (the point at which growth settles). This is intuitive because if a country has a level of capital below its optimum any investment undertaken will yield high returns. This will lead firms to invest in more capital. At this point the growth rate of the economy is very high. However the more firms invest, the greater the reduction in the marginal product of capital and the average product of capital (in other words they will be getting less and less for their investment). This in turn results in a reduction in the growth rate. This will reduce the quantity of savings available until there is only just enough to replace worn out machines and to equip new workers.
The diminishing marginal product of capital does however have further implications as it implies that all countries will converge to the same level of income with the same growth rate. This infers that poorer countries will grow faster than richer countries and eventually converge on the same income so long as the two economies are identical in all other respects. However this is not the case as the rate of technological progress is not the same anywhere in the world. If you make a comparison between Japan and Chad for example this is clear. Therefore it is essential to consider the effect of innovation and human capital on growth rates.
Research and development expenditure only constitutes approximately 2% of GDP in most countries but it has a substantial influence on growth. This is because knowledge is cumulative unlike, for example, machines which deteriorate. This means that countries that undertake research and development projects can have sustained growth in per capita output and face rising incomes. This underlines the importance of accumulating human capital through education and training. It is important to stress that human capital alone is not enough, as there are bounds to how much training can increase productivity. Those who do the most research and development do not necessarily have the highest growth rates. This is because it is cheaper for poorer countries to imitate products made by innovating countries than to innovate themselves. As they have cheaper per unit costs this can lead some poorer countries to grow faster than those on the World Technology Frontier.
This therefore explains why countries like the U.K may find it harder to grow compared to, say, Brazil. With Christmas coming up, inflation low and unemployment down the future looks bright for the U.K, but with our economy these days relying on so many other countries, who knows what the situation will be in six months time.