Fiscal policy impacts economic growth through various mechanisms. Government borrowing can crowd out private investment by raising interest rates, potentially slowing growth. Budget deficits also affect interest rates, influencing investment and consumer spending decisions.

Economic growth is driven by key factors like physical capital, human capital, and technological progress. These elements boost productivity and output, shaping an economy's potential. Various theories and models help explain the complex dynamics of long-term economic growth.

Fiscal Policy and Economic Growth

Crowding out and economic growth

• Government borrowing reduces private investment by competing for loanable funds (crowding out effect)
  • Issues bonds to borrow money, increasing demand for loanable funds (savings)
  • Raises interest rates due to higher demand for limited supply of funds
  • Makes borrowing more costly for private firms, discouraging investment (factories, equipment)
• Diminished private investment slows economic growth
  • Key component of GDP ($Y = C + I + G + NX$)
  • Less investment in physical capital hinders productivity growth (machinery, tools)
  • Reduced research and development spending impedes technological progress (new products, processes)
• The fiscal multiplier measures the impact of government spending on economic output
  • A higher multiplier indicates a greater effect on GDP growth

Budget deficits vs interest rates

• Budget deficits happen when government spending surpasses tax revenue
• Governments finance deficits by issuing bonds (borrowing)
  • Increases supply of government bonds, shifting demand for loanable funds rightward
  • Rightward demand shift raises equilibrium interest rates (price of borrowing)
• Higher interest rates can crowd out private investment
  • Businesses face steeper borrowing costs, limiting investment in capital and expansion (new stores, production lines)
  • Consumers may cut spending due to costlier loans and credit card rates (mortgages, auto loans)

Drivers of Economic Growth

Drivers of economic growth

• Physical capital investment boosts productivity and output
  • Includes tools, machinery, and infrastructure used in production (computers, assembly lines, roads)
  • Better and more abundant capital enables workers to produce more goods and services (cars, smartphones)
  • Enhanced productivity fuels economic growth (more output per worker)
• Human capital investment enhances labor force skills and productivity
  • Represents knowledge, skills, and abilities of workers (education, training, experience)
  • Education and training investments improve human capital (college degrees, vocational programs)
  • Skilled, productive workers generate more economic output (software engineers, surgeons)
• Technological progress propels long-term economic growth
  • Adopting new technologies amplifies productivity (automation, artificial intelligence)
  • Research and development (R&D) investment is essential for technological advancement (biotech, clean energy)
  • Improved technology streamlines production and spawns innovative products (3D printing, electric vehicles)

Growth Theories and Concepts

• Potential output represents the maximum sustainable level of production an economy can achieve
• Supply-side economics emphasizes the importance of increasing aggregate supply to stimulate economic growth
• Endogenous growth theory focuses on internal factors like human capital and innovation as drivers of long-term growth
• The Solow growth model, developed by Robert Solow, explains how capital accumulation, labor force growth, and technological progress contribute to economic growth