Economic Growth within the Macroeconomic Model
Introduction
A macroeconomic model is an analytical tool which is designated for identifying the economy of a country. The macroeconomic model is designed for describing the dynamics of aggregate quantities such as total income earned by citizens of a certain country, the level of unemployment of productive resources and the total amount of goods and services produced in the country. Macroeconomic models occur in a wide variety ranging from logic, mathematical applications as well as computational models. The varieties possess different purposes as each has its own merits and demerits hence a country adopts the most suitable for its economic growth. Countries use macroeconomic models to determine the effects of possible changes in the fiscal or monetary policies on the overall economic growth. Macroeconomic models are essential in determining the causes in addition to consequences of the business cycle as well as understanding the determinants of long-term economic growth as a result of increased national income. Economic growth is used to indicate the increase of per capita gross domestic product or any other measure of aggregate income. It is either positive or negative depending on the quantity of goods and services which are produced.
Discussion
The role of economic growth in macroeconomics
Economic growth is substantial in understanding long-run economic growth within a country as well as identifying the business cycle so as to stabilize short-run economic growth. Generally, when a country posts increased gross domestic product, economists relate that increase to p improved standards of living. Minimal increase of the annual growth rate of any country’s economy is fundamental in increasing the gross domestic product of the country especially where the monetary policies are favorable for business Mankiw, 2007).
Origin of economic growth concept
Economic growth is a concept which was formulated and established in the early modern period when Western European nationals discovered that economies could produce greater economic surplus which could in turn be spent on other aspects of the country. They described the activity of spending the surplus on projects which had a more direct impact on the nationals as well as improving their livelihoods, could lead to generation of more income for the country (Heijdra, and Ploeg, 2002).During the “Mercantilist” period, economic growth in a country was believed to be increased variety of goods and services which were circulating in the economy. At that period, testate controlled the transactions involving silver and gold which led to establishment of policies that saw trade being conduced through particular states and acquisition of colonies which supplied raw materials at a cheaper price. Such trading policies were aimed at promoting domestic trade until trading countries discovered that it was cheaper to import raw materials then export raw materials as a way of cutting off international competition.
After the business was fully established, the government could then increase the prices of the goods in order to recoup the expenses of establishing the business (Mankiw, 2007).Such policies allowed monopolies to set business all over the country and due to reduced competition, their businesses picked up quite fast and the country was able to increase its gross domestic product. According to the traders of this period, it was beneficial to trade with locals other than with international companies at equal, terms. This way, countries were able to grow economically through trade although trading with other countries was frowned at by the government (Snowdon, and Howard 2005).In the recent years it has been established that economic growth is directly proportional to frequent rapid replacement and reorganization of manpower which is boosted by high rates of investments. However, the increasing modification of cultural systems is unpredictable in a number of ways while at the same time it is highly creative and flexible. These unpredictable revelations have been counteracted by establishment of macroeconomic models which are quiet precise in determining the fate of a country’s economic growth (Heijdra, 2002).
Types of macroeconomic models in economic growth
Simple theoretical models
Examples of simple theoretical models include the IS-LM, Mundell Fleming model and the Solow model which is a neoclassical growth theory. These models tend to describe a country’s economy over long periods and are therefore equally important in forecasting the future of a country’s economic growth (Elhanah, 2004).
The Investment Saving and Liquidity preference Money supply model
The IL-LM macroeconomic model demonstrates the relationship between interest rates and the real output in the products which are available in the market as well as the financial market. At the point where the IS and LM curves meet, a general equilibrium is attained whereby a stable equilibrium in all markets of a country’s economy. This equilibrium presents a unique point where the product market is equal to the money market hence posting a stable interest rate and the gross domestic product at that point is real(Young and Darity, 2004).At the equilibrium, any form of spending is planned for such that there is minimal glut of goods and services. A country operating at this point exhibits a certain level of planned fixed investments dependent on the level of interest on the savings as lower interest rates have been known to encourage investments.
Alternatively, a higher level of saving requires that the income of the individual or investor is higher which raises the real gross domestic product which is substantial to achieving high national income and output ((Elhanah, 2004).Consequently, the rate of interest may be low but then the willingness of the investors to hold money due to emergencies as all business transactions demand that money exchanges hands. As the gross domestic product increases the need to spend in addition to business transactions tend to increase a higher rate hence the liquidity preference among the citizens increases as it is directly proportional to growth of the real gross domestic product. Similarly, the speculative demand for money which is inversely proportional to the interest rate decreases due to increased investment opportunities and increased opportunity cost of holding on to the finances (Mishkin, 2004).In such a situation, the money supply is dependent on the ability of commercial banks in individual countries to loan money to potential investors. Hence for any given level of income, the liquidity preference and money supply are directly affected by the interest rate offered by the money market. Therefore for a country to counteract this phenomenon, the gross domestic product has to be high so as to reduce the liquidity preference and in the course of achieving that objective, the interest rate will be increased (Young 2004).
Based on this interpretation, a government’s fiscal policy (deficit spending) has significant impacts similar to those of slower saving rates which increase the amount of aggregate demand for national income. Increased deficit spending by the government at a national level is affects the point of equilibrium as the investment savings will increase in a very steep gradient. However, some fiscal actions which derive support from the monetary sector may have minimal effects on money supply such that the demand of money will determine the aggregate demand (Heyne, Boettke, Prychitko, 2002).Deficit spending is often used by macroeconomics to stimulate the economy by discouraging fixed private investments while at the same time raising the interest rates. Research has shown that long-term economic growth of a country may be deluded by suppressing the potential output of the economy. However, if the deficits are spent on productive public investments such as public health which has direct impact on increased potential output, then it becomes beneficial for all(Diamond, 2006).The investment savings and liquidity preferential model has a crucial role in the monetary policy as money supply is detrimental to shifts of the LM curve such that the interest rate is lowered hence the equilibrium national income is increased. This often happens in the short-run when the prices of various products in the market are sticky and there are no indications of inflation in the economy (Young 2004).
The Mundell-Fleming macroeconomic model
This model was formulated by Robert Mundell and Marcus Fleming as a way of explaining the relationship between the nominal exchange rate and the country’s economy in an open economy. According to this model, an economy cannot sustain a fixed exchange rate, free capital movement and an independent monetary policy simultaneously. Hence it adopts various assumptions such as provision of equal interest rates locally and globally. However, in the business world the exchange rates are flexible as the government allows market forces to be the sole determinants of the exchange rates (Snowdon 2005).
Aspects of monetary policies on the model
A change in the amount of money being supplied reduces the interest rates within a country hence making it lower than the global rates. When this happens, the rate of exchange of local currency falls as highly valued money moves out of the local scene to the global market offering better rates. An economy which is affected by depreciating currency makes products cheaper in the local market as compared to foreign goods hence more exports are experienced as compared to imports. When this occurs, the local rates moves towards equalization with the global interest rates and the income of the country is increased due to increased exports (Mishkin, 2004).Sometimes in fixed exchange regimes, the central bank of the individual country is only capable of changing the money being supplied as a way of maintaining the specified rate of exchange. When the need to increase the exchange rate arises, the government purchases local currency to reduce the amount of money in supply and in the process the exchange rate is increased to its original level.
Alternatively, depreciation of the local exchange rate calls for the national government to purchase foreign currency with local currency and in so doing, the exchange rate is lowered to normal while the money supply is increased. This way a country is able to maintain its exchange rate at equilibrium with the global exchange rates (Mishkin, 2004).Changes in government spending also affect the economic growth of macroeconomics as it creates a huge impact on the national interest rate making it rise above the global interest rate. When this occurs, capital inflow is experienced in the country and the local currency is made stronger in relation to other foreign currencies. Therefore, imports are boosted while exports reduce hence low national income for the country until the government reduces its national spending and the local interest rate is reduces to a level where it is equal to the global rates (Young, 2004).
The Solow macroeconomic model
This model was formulated by Robert Solow in 1956 and it summed up economic growth as a an output which is produced by employing human capital as well as finances in a business where the demand and supply for labor are key determinants of the amount of labor used. This model lays an assumption that there is no unemployment in the economy or else it is less important in determining the fate of a country’s economy (Haines, 2006).The model shows that the long-run growth rate of a country’s economy is dependent on external factors such that a country which has adapted more advanced technology is predicted to grow at a faster rate than those who are not attached to technology. Similarly, the rate at which human capital grows and its availability are also fundamental in determining the positive economic growth. According to Solow’s model, technological progress is crucial to the growth of a country’s economy than the amount of finances accumulated over that period of time (Young, 2004).
Solow’s macroeconomic model as a neoclassical growth model predicts that poor countries have low income levels and for them to establish high income rates which are exhibited by other countries, they have to adapt similar features. For this to happen, the poor countries have to adopt conditional convergence in whereby the institutional arrangements, trade policy and educational policies of their countries are made to align with those of developed countries (Haines, 2006).The capital per worker policy is affected by three features: the amount of investment per worker, population growth in the country as increased population reduces the capital per worker level and depreciation of the stock market. This indicates that when the saving rate of citizens is higher than population growth or the rate of depreciation, then the capital per worker increases and the capital is said to be deep. This leads to increased growth domestic product and national economic growth spurts out (Diamond, 2006).Consequently, the rate of investment per worker may be greater than the amount needed to sustain a steady amount of income thus leading to increased output for the workers. When the capital per worker is not sustained, and population growth is exponentially increasing, the level of depreciation creates a huge rift in reducing the output of the worker hence the overall economic growth of the economy is thwarted (Haines, 2006).
Importance of the supply side of economic growth in a country
One of the crucial benefits derived by macro economies when the supply side is stable is growth of human capital. Human capital is defined as people who are available and willing to look for job opportunities. National fiscal policies which are aimed at increasing the amount of outputs usually increase the number of people willing to seek employment. Increased labor supply is directly proportional to high workforce and a lot of goods will be produced. This leads to positive economic growth of the economy (Snowdon, 2005)Similarly, the rate of capital investment of the citizens in a country has a direct impact on the gross domestic product of the country. This is fundamental when the government increases its spending power thus increase the amount of capital available for employees to work with as more money will be availed for training as well as improved employee safety.
When this is achieved, the workers will make use of newly gained skills to increase their performance and productivity hence more goods and services will be produced. Despite investing on workers, the government may make markets more competitive by improving their efficiency in order to achieve long-term economic growth. This is only achieved by regulating government fiscal policies so that its spending is directed towards improving the competence of workers (Mishkin, 2004).Improved technological advancements in a country are equally essential in reducing the cost of producing and supplying goods and services. This improves the quality of goods in addition to increased efficiency among workers as less time will be spent when closing business deals. The overall impact of embracing technology is opening of more flexible markets and reduced monetary policies by individual central banks on interest rates (Diamond, 2006).
Economic effects of fiscal policy
Fiscal policy is used by most governments to influence the status of aggregate demand in the economy. This is best done when the government modifies its spending rate as well as adjusting the tax rates imposed on various components of the economy. These two features are equally important when solving economic issues arising from recession and financial crisis. This acts as a cushion against inflation where the government steps in to stabilize the products of various goods and services. Consequently, deficits in a country are stabilized by public borrowing which in turn increases interest rates in the country hence reducing the aggregate demand. This facet leads to revelation of the relationship between fiscal policy and monetary policy as each is directly influenced by the other at this point (Heyne, 2002).
Economic effects of monetary policy
The central bank of individual countries dictates the monetary policy by influencing the interest rates as well as controlling the currency in circulation. When the central bank is aiming at increasing the amount of money in circulation, it lowers the rate of interest such that people are encouraged to invest by borrowing (Mishkin, 2004). Purchasing of government debts also increases the amount of money in circulation and in so doing, people are able to make new investments as well as spend more in increasing their competency hence improved standards of living in addition to productivity. When the situation normalizes, the central bank sells government debts as well as increasing the interest rates hence reducing the money in circulation. However, such distinct roles may run out of control especially where the central bank is greatly influenced by politician hence economic growth may stagnate (Olivei, 2002).
Conclusion
Macroeconomic models are significant in determining the future economic growth of a country. However, various measures have to be put in line as many external stimuli have greater impact on the overall economy especially in developing countries. The major macroeconomic models link monetary policy and fiscal policy to be key facets of a country’s economic growth. Both policies are dictated by local governments such that the success of a country’s economy is dependent on the decisions it makes in the course of its trading transactions. The rate of interest on borrowing as well as investments is used to determine the amount of money in circulation which is essential in determination of workers willingness to spend any money they could have accumulated.
Annotated Bibliography
Diamond, Jared. Collapse: How Societies Choose to Fail or Succeed. Penguin, 2006. London: OxfordUniversity Press
Elhanah Helpman, The Mystery of Economic Growth, New York: HarvardUniversity Press, 2004.
Haines, Joel D. (Competitiveness Review A framework for managing the sophistication of the components of technology for global competition. January 1, 2006) Volume 16; Issue 2; Page 106.
Heijdra, B. J.; Ploeg, F. van der, Foundations of Modern Macroeconomics, (2002)
Oxford University Press
Heyne, P. T., Boettke, P. J., Prychitko, D. L. The Economic Way of Thinking (10th ed). (2002): Prentice Hall.
Mankiw, N. Gregory Macroeconomics (6th ed.), (2007), New York: Worth publishers
Mishkin, Frederic S. The Economics of Money, Banking, and Financial Markets, (2004), Boston: Addison-Wesley, p. 517
Olivei, Giovanni P.. “Switzerland’s Approach to Monetary Policy”. New England Economic Review (Federal Reserve Bank of Boston) (Second Quarter): (2002) pp. 57-60
http://www.bos.frb.org/economic/neer/neer2002/neer202l.pdf.
Snowdon, Brian; , Howard R. Vane Modern Macroeconomics: Its Origins, Development And Current State, (2005), Edward Elgar Publishing
Young, Warren; Darity, William, “IS-LM-BP: An Inquest”, History of Political Economy. (2004)36 (Suppl 1): 127–164, doi:10.1215/00182702-36-Suppl_1-127.
Is this your assignment or some part of it?
We can do it for you! Click to Order!
