Theories of Economic Growth

The Theory of Economic growth is a Long Run theory. It concentrates on the effects of investment in raising potential national Income and ignores Short Run fluctuations of actual national income around potential income.

Ideas are changing rapidly in the area of economic growth. In order to present the subject of economic growth we must first state the two important factors that affect economic growth. First is the "Investment", the second is the "Saving".

Both saving and investment affect the level and the rate of economic growth. And the "Long Run" and the "Short Run" effects of these two factors help us understand their influences on the "Economic Growth Theory".

The National Income Determination Theory is a Short Run theory that takes potential income as constant and concentrates on the effects of shifts in the AD, due to chances in various types of expenditures. Whereas, in the long run, by the addition of capital stock, investment raises potential income, which shifts the LRAS curve continuously.

In the short run, any activity that puts income into people's hands will raise AD, whereas in the long run, the only factor that effects the potential growth is the part of investment that adds to a nation's productive capacity, which is not by a refilled hole, but by a factory.

The short run activity of an increase in saving is to reduce the AD, assuming, when people and government save more, they'll spend less. This will cause a downward shift in Aggregate Expenditure function, which will lower the AD, causing a lower equilibrium point.

When we look at the long run effects of saving function, we see that we have to save more now, in order to spend more later, because the investment function works this way. And, the higher the level of investment, the higher the level of real national income. A very important point is that, there's no "Paradox of Thrift" in the long run.

There are 4 major common determinants of economic growth (sited in our textbook) which are as follows :

I – Growth in the labour force
II – Investment in human capital
III- Investment in physical capital
IV- Technological change
Explanation of each factor :

I - Labour Force : In the case of economic growth, the country needs enough labour force to catch up with this economic growth and if this extra labour force is not satisfied, the economic growth will stop shortly after the human resources are fully used up. In order to achieve good performance in economic growth, population growth and participation rate increase is needed. There is a very important point that lies under the cover that if the population growth is faster than economical growth, this will cause a huge problem called ‘UNEMPLOYMENT’ which stops the economical growth by means of ‘Inflation’ and other major issues. This damages the country’s economy deeply.

II- Investment in Human Capital : Examples are on-the-job experience and formal education. As the technology improves, the new inventions (which are helpful and much more reliable and profitable to use) brings up a problem which is: ‘Who will operate these new machines?’. The perfect answer is that the educated and trained personnel. And as the technology improves, the need for better international relations comes up with the language problem since there is no universal language that everyone on the planet speaks. That is why today’s businessman speaks more than one foreign language fluently. This helps them get good partitions from the international trade mechanism which is very much dependant on the latest communication equipment.

III- Investment in Physical Capital : Examples are factories, machinery, transportation and commmunication facilities. As more and more factories are opened, more employee will be a necessity just like when you have more machinery in the company you’ll need more personnel to operate them. What this does is that it opens up new areas of employment and the growth in these areas is covered by placing more and more workers to more and more available places that come up with the growth of physical capital. The second major issue is that more physical capital helps you overcome the competitors who use less and/or older technology machinery/equipment, keeping in mind that mass production of a material that the new/improved technology builds costs less than the same