Macroeconomics - AS Costs and Benefits of Economic Growth

 Writing skills - AS Level         Example 1

From 2004 to 2018 the Ethiopian economy grew at an average rate of over 10% per

year. Over this period there has been significant deforestation in the country. Forests

have been cleared to make space for farming and the wood has been used for fuel

and construction.

Evaluate whether the costs of economic growth outweigh the benefits.

AS Costs and Benefits of Economic Growth

Possible answer – 

Let me start with presentation of my basic understanding on economic growth, Economic growth is a measure that shows an increase in the percentage of production of all goods and services in an economy in one year compared to the previous year.

Economic growth is always perceived as a good way to improve the living standard of the people as it causes higher production of all goods and services compared to the previous year, increasing more employment and income among people. 

As Ethiopia has grown at an average rate of over 10% per year, so it is likely that people of Ethiopia have experienced higher employment and income.

Though Ethiopia`s higher economic growth has some benefits, but not without the costs. Let us discuss some the costs of the Economic growth of Ethiopia.

Impact on the environment - higher economic growth in Ethiopia came at the cost of higher rate of deforestation as it is mentioned in the case above. This would definitely have a greater impact on the environment as it would cause various problems including soil erosion, loss of habitats for the rare species and unwanted climate change leading to floods and increase in temperature in the country. All these factors would impact the economic activities and the living standard of the people in the country in the long run. 

Besides, forest land used in agriculture after cutting the trees will cause further land and water pollution if fertilizers are used in farming process. Use of fertilizer causes land productivity to decrease, whereas the ground water and the nearby water bodies get polluted. This causes drinking water scarcity within the local areas. 

It is also mentioned in the case study that the forest materials such as woods are being used as fuel and construction materials in the country to fuel the economic growth. Woods could be a cheaper option to substitute oil, but it does provide any relaxation when it comes to avoiding pollution. Worse part is, unlike oil, there is a need of huge amount of wood to be burnt to generate energy. This may cause unleashing a huge amount of CO2 into the atmosphere that could impact millions of lives because of its negative impacts. This negative spillover effects on the society is called external costs. Such external costs include higher carbon dioxide particles into the atmosphere leading to chronic diseases like cancer and bronchitis. Situation could be worse further if Ethiopia had used fossil fuel to achieve their higher economic growth. This means the effects of external costs would be far more than that of use of only woods as fuel to achieve the higher economic growth.

Beside the environmental effects there may have some other negative effects of economic growth. Let me analyze those below.

Depletion of resources – as Ethiopia tried to increase its economic growth, it must have used its non-renewable resources extensively such as oil, coal or iron ore etc. Without using them, it won`t be easy to maintain such a high rate of growth up to 10% at an average for such a long time. This means, Ethiopia may not have those resources again at the same quantities to sustain its economic growth over the longer period of time. As a result, the current economic growth could be at the cost of the future economic growth leading to a lower living standard for the future generations in Ethiopia.

Inflationary pressure – as Ethiopia has enjoyed the higher economic growth since 2004 to 2018, so it is likely that the income among people must have increased, making them able to fund their consumptions more than before. This higher consumption would definitely cause the output to increase beyond the level of full employment (if it was already operating at full employment) leading to an inflationary pressure in the economy. Here to mention that, increase in AD takes place, if any one of the components of AD such as consumption spending, investment spending, government spending or next exports increases. Considering the fact, that higher economic growth leads to higher income among people, which in turn, leads to higher consumptions and investment spending (due to the animal spirit effect), it would not be wrong to say that Ethiopia would experience the same or probably have already experienced the same. As a result, sooner or later, they will find their consumption spending and investment spending will be uncontrollable leading to an increase in AD. This increase in AD leading to inflation in the economy is called demand-pull inflation (Figure 1). 

Figure 1: Inflationary pressure and Demand-Pull Inflation

AS Costs and Benefits of Economic Growth

This demand-pull inflation has got many adverse effects on the economy such as, wage inflation spiral, decrease in value of the paper currency, loss of confidence among buyers and sellers, hyperinflation, and loss of price competitiveness in overseas market leading to lower unemployment and slower economic growth in the future.

Balance of trade deficit – Higher economic growth leads to a greater income among people in the country. This causes higher confidence among buyers to increase their consumption in all spectrum, which leads them to import more foreign goods. If the value of imports overshadows the value of exports, then it causes balance of trade deficit. If the deficit is not balanced with surplus soon, then the country may not be able to import necessary commodity or resources to continue their production anymore. As they may lack enough foreign currency funds to make payments for their overseas purchases. This may cause halt in production across all the industries leading to an economic crisis in the country. If there is an economic crisis, then it would damage the Ethiopian economy leading to a lower future economic growth and living standard among people. Though there is no evidence to prove that Ethiopia is going through such economic crisis now, but surely it will head towards that if the situation is not brought under control before imports takeover the exports. Here to note that, higher economic growth availing higher income among people to fund their consumptions may cause importation of higher raw material from other countries. This has got potential to cause a trade deficit, if the equal value output produced using the imported resources are not exported to other countries. So, Ethiopia is suggested to take precaution beforehand, otherwise, it may cause a crisis leading to a poor economic condition and a lower living standard for the people of Ethiopia.

Opportunity cost of the economic growth – Though the economic growth has been higher since 2004 to 2018 in Ethiopia, this means, they have diverted their resources from the production of consumer goods to the production of capital goods to enjoy the higher economic growth for long time. Here to note that, diverting resources from production of consumer goods to capital goods would cause lower amount of consumer goods to be produced leading to a lower living standard among people in the short run. It is likely that Ethiopia must have gone through the same stage, when living standard among people in Ethiopia must have been sacrificed to enjoy the higher economic growth in the future. And that is why they must have decided to divert the resources from production of consumer goods to capital goods. As a result, they must be enjoying higher living standard now but not without letting their people to bear the lower living standard at past. 

Income inequality – Economic growth causes national income of a country to increase, as a result, it is expected that higher income will cause higher living standard among people. This is likely to occur if the national income is distributed among people equally. If the greater portion of national income goes to the smaller portion of the population, then it is likely that the living standard among people on an average will decrease. This would be the case with Ethiopia, if the government of Ethiopia has not distributed the national income among people equally.

However, economic growth does not always have costs, rather there may have plenty of benefits. Let me discuss those below.

Higher living standard – as economic growth causes higher income among people, so they would be able to fund their consumption more than before leading to a higher living standard among people. Besides, higher income among people also means people can buy higher value goods. This may lead to higher production of high value goods that can be consumed by the greater part of the population leading to an increase in living standard among people. Same is true in case of Ethiopia as Ethiopian people could be able to consume more output which are higher in value leading to an increase in living standard among them.

Better society – it is likely that higher economic growth in Ethiopia may lead to higher income among people leading to less population living under poverty as a consequence. As a result, people will have no reason to involve in criminal activities. This will cause greater harmony and trust among people leading to safe society and greater quality of life. 

Lower unemployment – higher economic growth means higher production of output which needs  more employment of resources. As a result, unemployment of resources goes down. For example, let us assume that before 2004, the employment of resources in Ethiopia was less than full employment which represented as negative output gap or deflationary gap. As Ethiopia experienced higher economic growth between 2004 to 2018, so it is expected that Ethiopia must have utilized all its resources efficiently and moved towards full employment leading to have narrowed negative output gaps. Lower unemployment of resources due to narrowed output gap means more people were at work and greater deals for resource owners. As a result, higher income for them. This would definitely cause higher consumption leading to higher living standard among people. Lower unemployment also means that the Ethiopian government does not have to spend money on unemployment benefits or welfare benefits much. As a result, government can use the funds to improve the public services or may use it to pay back their debts.

Hysteresis problem can be avoided - Higher economic growth leading to lower unemployment may also cause Ethiopia not to experience a problem like Hysteresis where people lose their skills if they are out of work for long time leading to submerge into a long term unemployment. As hysteresis causes the productive potential of a country to decrease, people are forced to living in poverty with lower living standard. Fortunately, Ethiopia has not experienced such problem as the country has been enjoying higher economic growth for long time leading greater living standard among people.

Government budget - As Ethiopia enjoyed higher economic growth between 2004 to 2018, it is likely that per capita income among people have increased. This higher income they might have used to buy more goods and services. This increase in income and consumption among people could have created an avenue for government to collect more taxes. It is likely that higher income among people caused higher income tax collection, at the same time, higher consumption caused higher indirect tax revenues for the Ethiopian government. Sum total of both tax collections must be far greater than before, which means government of Ethiopia would have enough funds to fund various projects that must have led to greater public services such as providing access to clean water leading to greater convenience among people. As a result, living standard among people in Ethiopia must have increased. 

Animal spirits - As Ethiopia enjoyed higher economic growth for a very long time causing higher income among people, leading to a greater amount of confidence among them to spend money. This would have definitely encouraged firms to respond to the higher demand in the market by investing more, as they could sense the positivity in the market. This ability to sense the positivities in the market and then act on it to capitalize the opportunities is stated as animal spirits. It is possible that producers in Ethiopia might have felt the animal spirit from the beginning, which led them to increase their capacity to serve the higher demands in order to enjoy higher profitability. As a result of this animal spirits, producers might have increased their production capacity, which in turn, must have led to employment of many people causing to higher income and higher living standard among people of Ethiopia. 

One very good thing about animal spirit is that, as it encourages firms to increase their capacity, it leads to increase in productive potential of an economy. This is really good for an economy as it shifts the LRAS to the right leading to have a lower price level in the economy (Figure 2). If in case, AD increases, then it does not cause huge rise in price level as the economy has already created the greater capacity to satisfy any short run rise in AD without necessarily creating any huge inflationary pressure. This means, economic growth with less inflationary pressure. Ethiopia might have enjoyed the same. 

Figure 2 : Effect of Investment

AS Costs and Benefits of Economic Growth

To conclude, I would like to say that, whether costs of economic growth outweigh the benefits of economic growth depends on the intensity of the factors. If the factors like high inflation, negative impact on the environment, income inequality and depletion of resource play major role to increase the costs of economic growth than the benefits of economic growth, then costs of economic growth will outweigh the benefits of it and vice-versa.