TOPIC 4

MONEY AND ECONOMIC GROWTH:

Part 1: Economic Growth

Economic growth is an increase in the production of economic goods and services in one
period of time compared with a previous period. It can be measured in nominal or real
(adjusted to remove inflation) terms. Traditionally, aggregate economic growth is measured
in terms of gross national product (GNP) or gross domestic product (GDP), although
alternative metrics are sometimes used.
Note: GDP measures the value of goods and services produced within a country's
borders, by citizens and non-citizens alike.
GNP measures the value of goods and services produced by a country's citizens, both
domestically and abroad.
GDP is the most commonly used by global economies. The United States abandoned
the use of GNP in 1991, adopting GDP as its measure to compare itself with other
economies.

Economic growth refers to an increase in the real output of goods and services in the country.
Growth relates to a gradual increase in one of the components of Gross Domestic Product:
consumption, government spending, investment, net exports, savings etc.
Economic Growth is measured by quantitative factors such as increase in real GDP or per
capita
Income.

Stages/Cycles of Economic Growth (Real Business Cycle (RBC) model)

The economic cycle is the fluctuating state of an economy from periods of economic
expansion and contraction. It is usually measured with the Gross Domestic Product (GDP) of
a country or region. Other economic factors, such as employment rates, consumer spending,
and interest rates, can also be used to determine the stage of the economic cycle.

The economic cycle is also known as the business cycle, and it is the fluctuating state of a
market-based economy. An economy is a term that describes a set of production and
consumption activities that determine how resources ought to be allocated.
Real GDP and unemployment are the two key economic indicators used in the analysis of the
economic cycle. Economic cycle analysis is best suited to market-driven economies.
In today’s world, virtually every economy is a market-based economy in which the laws of
supply and demand determine prices.
Supply and demand pressures influence the economy through different variables, such as
global economic conditions, trade balances, productivity, inflation rates, interest rates, and
exchange rates. The variables, in aggregate, shape the economy and the state of the economic
cycle.
The economic cycle is a trend of upward and downward movements of GDP that ultimately
determines the overall long-term growth of an economy.
GDP measures the aggregate value of goods an
d services and is used to depict the overall wealth of an economy. Higher GDP usually
correlates with more well-off citizens.

Stages of the Economic Cycle

Phase 1: Expansion (Boom). During the expansion phase, interest rates are often on the low
side, making it easier for consumers and businesses to borrow money. The demand for
consumer goods is growing, and businesses begin ramping up production to meet consumer
demand. To increase production, businesses hire more workers or invest capital to expand
their physical infrastructure and operations. Generally, corporate profits begin to rise along
with stock prices. Gross domestic product (GDP) also begins rising as the economy gets its
“boom” cycle underway.
This leads to higher output, increased employment, and a general improvement in economic
conditions.
Phase 2: Peak. At this stage, the economy reaches a maximum rate of growth. As consumer
demand rises, there’s a point at which businesses may no longer be able to increase
production and supply to match the increasing demand.
The peak represents the highest point of the business cycle, characterized by maximum
output, employment, and overall economic activity.
The economy is at maximum production capacity.
Some companies may find it necessary to expand production capabilities, which entails more
spending or investment. Businesses may also begin experiencing a rise in production costs
(including wages), prompting some to transfer these costs over to the consumer via higher
prices.
Consequently, businesses may begin to see a “topping-off” in profits despite charging higher
prices. Other businesses will see decreasing profits due to higher manufacturing (input) costs
or higher wage demands. Overall, inflationary pressures start to build up, or “bubble,” and the
economy begins to overheat.

Phase 3: Contraction. Then the economic contraction begins. In this stage, corporate profits
and consumer spending, particularly on discretionary (e.g., luxury) items, begins to fall.
Stock values also decline as investors move their investments to “safer” assets such as
Treasury bonds and other fixed-income assets, plus good ole cash. GDP contracts due to the
decrease in spending.
Production slows to match falling demand. Employment and income can also decline as
businesses temporarily freeze hiring or resort to laying off workers. Overall, economic
activity slows, stocks enter a bear market, and a recession typically follows.
Sometimes a recession is mild, but other contractions—such as the Great Depression—are
particularly severe and long-lasting. In a depression, many businesses close up shop for good.
If the economy looks to be suffering a severe contraction, monetary and fiscal policy may be
implemented. For instance, the Central Bank tends to lower interest rates so that consumers
and businesses can borrow money on the cheap for spending and investment.

Phase 4: Trough. The trough is the lowest point in the business cycle. Economic activity
reaches its lowest levels, and output is at its minimum.
Unemployment is typically high during this phase, and there is excess capacity in the
economy.
At this point, the economy begins the cycle anew. Policies enacted during the contraction
phase begin to bear fruit. Businesses that retrenched during the contraction begin to ramp up
again. Stock values tend to rise as investors see greater potential returns in stocks than bonds.
Production ramps up to meet rising consumer demand and with it, business expansion,
employment, income, and GDP.

Part 2: A review of Keynesian and Neo-classical barter growth models

Keynesian and neoclassical models are economic frameworks used to analyze economic
growth, but they approach the topic from different perspectives and make different
assumptions about the functioning of markets and the behavior of economic agents. In the
context of economic growth, we can discuss their approaches and key differences.

Keynesian Growth Model:

The Keynesian approach to economic growth is based on the ideas of John Maynard Keynes,
who emphasized the role of aggregate demand and the importance of government
intervention in the economy to achieve full employment and economic stability. The
Keynesian growth model focuses on short-term economic dynamics, emphasizing the role of
government spending, consumption, and investment to stimulate economic growth.

Keynesian economists believe that the government should play an active role in managing
aggregate demand. They argue that the government can boost economic growth by increasing
government spending or cutting taxes. This will increase aggregate demand, which will lead
to higher output and employment.

Key Features:
 Government intervention: Keynesians believe that government intervention,
particularly through fiscal policy (government spending and taxation), is
crucial to manage aggregate demand and stabilize the economy.
  Aggregate demand: Economic growth is influenced by changes in aggregate
demand, and policies should be geared towards boosting demand during
economic downturns.
 Consumption and savings: Consumption plays a major role in driving
economic growth, and changes in consumption patterns are important for
economic expansion.
Neoclassical Growth Model:
The neoclassical growth model is based on the principles of classical economics and
neoclassical microeconomic theory. It focuses on long-term economic growth and
emphasizes the role of factors such as technology, capital accumulation, and labor
productivity in driving economic expansion. Neoclassical economists typically stress the
importance of free markets and minimal government intervention.

Neo-classical economists, on the other hand, believe that the government should play a
limited role in the economy. They argue that the market is self-correcting and that the
government should not interfere in the market process. However, they do support government
policies that promote economic growth, such as investing in education and infrastructure.

Key Features:
 Market mechanisms: Neoclassical economists believe that free markets are
efficient and that they allocate resources optimally for long-term growth.
 Savings and investment: Savings and investment are critical for capital
accumulation, which in turn drives economic growth. Increases in capital per
worker lead to increased output and productivity.
 Technological progress: Technological advancements and improvements in
productivity are considered key drivers of long-term economic growth.
Key Differences:
Government Intervention:
 Keynesian: Advocates for active government intervention, especially during
economic downturns, to boost aggregate demand and stimulate economic growth.
 Neoclassical: Emphasizes minimal government intervention, allowing market forces
to determine resource allocation and growth.
Role of Markets:
 Keynesian: Views markets as imperfect and subject to fluctuations, requiring
government intervention to stabilize and promote growth.
 Neoclassical: Believes in the efficiency of markets and their ability to promote
growth through individual decisions and competition.
Focus and Time Frame:
 Keynesian: Focuses on short-term economic fluctuations and aims to stabilize the
economy in the short run.
 Neoclassical: Focuses on long-term economic growth and the factors that drive
sustained increases in output and productivity over time.