Economic Development Growth & Capital Formation

Economic Development Growth & Capital Formation Note PDF

What is Economic Growth?

Economic growth can be referred to as the increase that is witnessed in the monetary value of all the goods and services produced in the economy during a time period. It is a type of quantitative measure that reflects the potential increase in the number of business transactions taking place in the economy.

It can be measured in terms of the increase in the aggregate market value of additional goods and services produced by using economic concepts such as GDP and GNP.

Economic growth is a narrow concept when compared to economic development.

KEY TAKEAWAYS

  • Economic growth is an increase in the production of goods and services in an economy.

  • Increases in capital goods, labor force, technology, and human capital can all contribute to economic growth.

  • Economic growth is commonly measured in terms of the increase in aggregated market value of additional goods and services produced, using estimates such as GDP.

  • The four phases of economic growth are expansion, peak, contraction, and trough.

  • Tax cuts are generally less effective in spurring economic growth than are increases in government spending.

  • If the rewards of economic growth go only to an elite group, then it is unlikely that the growth will be sustainable.

What is Economic Development?

Economic development refers to the process by which the overall health, well-being, and academic level of the general population of a nation improves. It also refers to the improved production volume due to the advancements of technology.

It is the qualitative improvement in the life of the citizens of a country and is most appropriately determined by the Human Development Index (HDI). The overall development of a country is based on many parameters such as the creation of job opportunities, technological advancements, standard of living, living conditions, per capita income, quality of life, improvement in self-esteem needs, GDP, industrial and infrastructural development, etc.Capital Formation: Definition, Example, and Why It’s Important.

Understanding Economic Growth

In simplest terms, economic growth refers to an increase in aggregate production in an economy, which is generally manifested in a rise in national income.Often, but not necessarily, aggregate gains in production correlate with increased average marginal productivity. That leads to an increase in incomes, inspiring consumers to open up their wallets and buy more, which means a higher material quality of life and standard of living.

In economics, growth is commonly modeled as a function of physical capital, human capital, labor force, and technology. Simply put, increasing the quantity or quality of the working age population, the tools that they have to work with, and the recipes that they have available to combine labor, capital, and raw materials, will lead to increased economic output.

Phases of Economic Growth

The economy moves through different periods of activity. This movement is called the “business cycle.” It consists of four phases:3

  • Expansion – During this phase employment, income, industrial production, and sales all increase, and there is a rising real GDP.

  • Peak – This is when an economic expansion hits its ceiling. It is in effect a turning point.

  • Contraction – During this phase the elements of an expansion all begin to decrease. It becomes a recession when a significant decline in economic activity spreads across the economy.

  • Trough – This is when an economic contraction hits its nadir.

A single business cycle is dated from peak to peak or trough to trough. Such cycles generally are not regular in length, and there can be a period of contraction during an expansion and vice versa.

Since World War II, the U.S. economy has experienced more expansions than contractions. Between 1945 and 2019, the average expansion lasted about 65 months, while the average contraction was only 11 months. However, the Great Recession, from December 2007 to June 2009, went on for 18 months. This was followed by the longest expansion on record, 128 months, lasting until 2020 and the advent of the COVID-19 pandemic.

How To Measure Economic Growth

The most common measure of economic growth is the real GDP. This is the total value of everything, both goods and services, produced in an economy, with that value adjusted to remove the effects of inflation. There are three different methods for looking at real GDP.5

  • Quarterly growth at an annual rate – This looks at the change in the GDP from quarter to quarter, which is then compounded into an annual rate. For example, if one quarter’s change is 0.3%, then the annual rate would be extrapolated to be 1.2%.

  • Four-quarter or year-over-year growth rate – This compares a single quarter’s GDP from two successive years as a percentage. It is often used by businesses to offset the effects of seasonal variations.

  • Annual average growth rate – This is the average of changes in each of the four quarters. For example, if in 2022 there were four-quarter rates of 2%, 3%, 1.5%, and 1%, the annual average growth rate for the year would be 7.5% ÷ 4 = 1.875%.

Capital Formation: Definition, Example, and Why It’s Important.

What Is Capital Formation?

Capital formation is the net capital accumulation during an accounting period for a particular country. The term refers to additions of capital goods, such as equipment, tools, transportation assets, and electricity.

KEY TAKEAWAYS

  • Capital formation is the net accumulation of capital goods, such as equipment, tools, transportation assets, and electricity, during an accounting period for a particular country.

  • Generally, the higher the capital formation of an economy, the faster an economy can grow its aggregate income.

  • To accumulate additional capital, a country needs to generate savings and investments from household savings or based on government policy.

  • When investors purchase stocks and bonds issued by corporations, the firms can put the capital at risk to increase production and create new innovations for consumers.

  • The World Bank tracks gross capital formation, which it defines as outlays on additions to fixed assets, plus the net change in inventories.

Understanding Capital Formation

Countries need capital goods to replace the older ones that are used to produce goods and services. If a country cannot replace capital goods as they reach the end of their useful lives, production declines. Generally, the higher the capital formation of an economy, the faster an economy can grow its aggregate income.

Producing more goods and services can lead to an increase in national income levels. To accumulate additional capital, a country needs to generate savings and investments from household savings or based on government policy. Countries with a high rate of household savings can accumulate funds to produce capital goods faster, and a government that runs a surplus can invest the surplus in capital goods.

Example of Capital Formation

Caterpillar is one of the largest producers of construction equipment in the world. It produces equipment that other companies use to create goods and services.

Caterpillar (CAT) is a publicly traded company and raises funds by issuing stock and debt. If household savers choose to purchase a new issue of Caterpillar common stock, the firm can use the proceeds to increase production and develop new products for the firm’s customers.

When investors purchase stocks and bonds issued by corporations, the firms can put the capital at risk to increase production and create new innovations for consumers. These activities add to the country’s overall capital formation.

Reporting on Capital Formation

The World Bank works as a source of financial and technical assistance to developing countries, with an aim to end extreme poverty through its programs. The World Bank tracks gross capital formation, which it defines as outlays on additions to fixed assets, plus the net change in inventories. Fixed assets include plants, machinery, equipment, and buildings, all used to create goods and services. Inventory includes raw materials and goods available for sale.

The World Bank measures capital formation by assessing the change in net savings. If the household savings rate is increasing, savers may invest additional dollars and purchase stocks and bonds. If more households are saving, the country may report a cash surplus, which is a positive sign for capital formation.

Why is capital formation important?

Capital formation essentially leads to more money swirling around the economy. The accumulation of capital goods translates to investment and the production of more goods and services, which should boost the income of the population and stimulate demand.

What factors affect capital formation?

Capital formation doesn’t happen on its own. It depends on the income of the people living in the country and their capacity to save and spend.

What are the steps in capital formation?

Capital formation occurs when the population has enough income to save and invest. It starts with the creation of savings and is realized when those savings are invested.

Also check,

Importance of Microeconomics in Business Decision Making

https://en.wikipedia.org/wiki/Capital_formation

https://en.wikipedia.org/wiki/Economic_development

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