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the trend growth rate and measurements of economic welfare

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Alex Potter 6N2                                                                            3rd March 2009

Economics Essay

  1. What determines the trend growth rate in the United Kingdom? (20)

First and foremost the trend growth rate can be defined as an averaged total of economic growth, illustrated in a linear format on a graph over a 12 month period, or alternatively as the mean growth rate during an economic cycle. The trend rate of economic growth is determined by taking the percentage change in Real GDP (adjusted for inflation) over the course of a year. Compiled in this manner, it allows considerable fluctuations in output to be smoothed - providing more reliable figures.

An output gap exists when there is a differential between the trend rate of economic growth and the actual GDP. A positive output gap usually occurs when the economy is in a “boom” period, whereby the current output lies above the trend. This can be illustrated on figure 1 below, where the horizontal line converges between C and D.

Figure 1

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Similarly, a negative output gap can be shown between the other horizontal line, this time going from A to B. Conditions such as these typically occur during recessions (whereby there is two consecutive quarters of negative economic growth).

There are many factors which can have a direct influence upon the trend growth rate in the UK:

Perhaps rather surprisingly, climatic factors play a major role in determining the trend rate of output growth. Variations in sunspots affect the power of the sun’s rays, which consequently has a significant influence on the quality of the crop harvest and therefore the price of the commodities sold, which in turn promotes greater economic confidence and leads to the achievement of larger profits earned, these profits can then be reinvested into the circular flow of income – leading to further growth.

Another factor is the role of speculative bubbles; rapid economic development and growth usually leads to hasty asset price increases. Once it begins to dawn on consumers that market prices for property and shares etc have risen far above their “Real” values, then mass selling of a wide range of financial and non financial assets begins to take place. A very recent example of this effect is the ongoing global credit crunch beginning in 2008. Although house prices have fallen dramatically, the evidence of destruction as a consequence of rapid asset selling has been seen more obviously in the financial markets, whereby shares are now experiencing a bear market (where values have plunged to less than 20% of their previous peak). The effect of this quick fire selling is that the speculative bubble bursts very quickly, this implosion inevitably destroys consumer and business confidence. This then unfortunately leads to an economic recession as consumers cut back dramatically on their spelling.  

Political business cycle theory applies to democratic countries which have national elections every four or five years. As an election approaches, the party in power may decide to “buy votes” by initiating a pre election boom in aggregate demand and supply, this decision  has a direct influence upon the country’s trend  rate of economic growth -  indeed it is highly likely that the trend  rate will increase in the short term as a consequence. However, after the election (providing the ruling party wins again), then the government will cut back on spending in the economy, in order to prevent it from experiencing inflationary pressure from excess consumption.

Finally, “outside shocks” directly impact the trend rate of an economy’s output per year. These external blows can be categorised further, into aggregate demand and supply shocks. The fairly recent example of 9/11 can be used to highlight the substantial negative impact an unforeseen terrorist act can have on consumer and business confidence in the western world. The reduction in aggregate demand that resulted signalled to suppliers of goods and services that it was time to cut back on their production, which consequently led to a drop in aggregate supply also. The overall result of this period of economic nervousness was a short term fall in the trend rate of economic growth for MEDCs as caused by an initial negative output gap.

2. How best should improvements in economic welfare be measured? (30)

The theory of economic welfare has long served as an expansive source of argument amongst economists; it can generally be defined as the level of prosperity and the quality of living standards prevalent within an economy.

The standard measurement of improvements in economic welfare is national income statistics. These figures are often used to indicate current levels of economic growth and social welfare in numerical terms; as a result the absolute figures produced can be directly compared with other countries.

The traditional method of calculating welfare growth within an economy/society has been to use real per capita GDP figures. This measurement is undertaken by taking the gross domestic product (the total value of goods and services produced within an economy, through a single financial year), adjust the result for inflation, then to divide the figure produced by the total population in order to achieve an average figure of economic welfare progression.

Aggregate demand and supply diagrams can be analysed to see where the equilibrium level is situated, and also to understand the underlying fundamental factors behind one country’s greater economic welfare growth in relation to another.  For example as figure 1 shows below, AD1 shifts rightwards to AD2, which then leads to an extension in national income (in this case GDP) from Q1 to Q2.

Figure 1

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Many liberal politically inclined individuals concede that income is an imperfect measurement of economic welfare and stress its shortcomings, whereas conservative economists have tended to emphasize its virtues. However, the debate is not merely of philosophical interest; it also carries with it important policy implications.

Although rising real GDP per capita generally indicates that living standards are rising in close correlation too, some figures conceal considerable and sometimes growing disparities in the income distribution of their country. This problem is especially significant in newly industrialising countries, where GDP growth is often expansive, but yet typically the income distribution is extremely unequal. In examples such as these, only a small fraction of the population in question may actually benefit from the economic growth, let alone experience any form of advancement in welfare.

In the three decades following the Second World War, the relationship between income and well being was not a contested issue; this was due to the fact that incomes were growing at about the same rate for all groups in the labour market. However ever since the early nineteen eighties, income growth in the United Kingdom has been confined almost exclusively to only the top earners. So therefore as previously mentioned, any change in per capita GDP, which only tracks the developments in the average income, must fail to account for the actual effects of this shift.

Perhaps when governments undertake GDP growth calculations they may do well to look are the Gini coefficient also; which is a graphical representation of an income distribution, illustrated through a linear curve.

image03.png

The Gini coefficient is the area between the line of perfect equality and the observed Lorenz curve for a particular country/economy, it is expressed as a percentage of the area between the line of perfect equality and the line of perfect inequality. The higher the coefficient (i.e. how close it is to the figure of 1), the more unequal the distribution is.

The assumption which lies behind the traditional economic models of economic welfare developments is that absolute income levels are a primary determinant of individual well being. This criticism has been developed extensively within the last few years, so much so that now there is a whole host of different types of welfare measurements which are used by numerous governments, that do take account of negative externalities as a result of economic growth, in addition to the acknowledgement of the importance of an increasing quality of life as incomes grow also.

Take China, for example, over the last twenty years the economy has gone from strength to strength, it is now ranked as the second largest only to the USA in the world. Clearly in numerical terms, the national income and raw figures suggest that China is a more economically successful nation than the UK in every other way, however once other major factors (not necessarily monetary) are considered, indeed it may be foolhardy to assume China as the superior country.  

To quote Simon Kuznets, the inventor of the GDP calculation, “the value of a nation can scarcely be inferred from a measurement of national income”. Therefore perhaps unsurprisingly, over recent years numerous other measures are being utilised in order to place a value on economic and social progress. Some examples include:

The “human development index”, which is composed by the United Nations and is an average of three indicators; the standard of living - as measured by real GDP per capita which is valued at US Dollars purchasing power parity, life expectancy at birth - measured in years and finally the educational attainment of a country’s inhabitants, this final factor is calculated by taking a weighted average of adult literacy and an enrolment ratio in schools and colleges. The closer a nation’s end figure is to 1, the greater its human development and economic welfare is ranked as.

Another method is “the index of sustainable welfare” which is very much a pro environmental method of calculation. It its creation, no form of negative externality is omitted, also all forms of intangible assets (which are usually hidden in orthodox measurements) are actually accounted for and are assessed relative to their significance to the societies economic welfare.

And finally one other alternative measure could possibly be happiness surveys such as “the happy planet index”, whereby individuals within a country are asked to fill in a subjective questionnaire regarding the quality of their lives. The advantage of this method is that social welfare and sustainability are accounted for as well as financial progression The only problem being that it is rather difficult to undertake, the best method is to ask the population to rate their access to essential public services, such as education and health care, in addition to the rating of the quality of their lives – perhaps providing a figure between 1 and 10 indicating their satisfaction. The end result of this happiness survey is to conclude with an average numerical figure, representative of the general happiness of a country’s population.

In conclusion, it is essential that a society which aspires to improve has an abundance of differing welfare measurements which its government can utilise in order to take account of the expansive differences and variables prevalent within a modern economy. Without these clear indications of economic progress, it is almost impossible to account for any developments whatsoever, and especially difficult to detect where future improvements need to be made through the implementation fundamental economic policies et cetera.

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