Wednesday, May 23, 2007

Essay: Domestic Demand and Economic Growth

"Examine the factors which might explain why 'strongly rising domestic demand has run ahead of overall economic growth" [60]

Basically, the question is asking "why is domestic demand increasing at say 4-5% per year, but economic growth is only increasing at say 2%"

These are some factors, which may explain the unbalanced growth the UK has seen in recent years:

1. Rising House Prices.

House prices have doubled in past 6 years. Rising house prices lead to an increase in consumer wealth. This increases consumer confidence, and also, homeowners can remortgage to get equity withdrawal. Therefore, rising house prices have led to higher consumer spending. This is a significant factor in increasing consumer spending because 75% of households own their house; housing is also the biggest form of wealth of UK. However, rising house prices do not increase the productive capacity of the economy. This has been a big factor in increasing domestic demand at a faster rate than economic growth.

2. Lower Real Interest Rates

Lower interest rates make it more attractive to borrow and therefore lead to an increase in consumer spending. Lower interest rates have also contributed to a fall in the savings ratio; this means savings are falling and consumer spending is rising as a % of net income. This explains why domestic demand is outstripping demand. A fall in the savings rate theoretically leads to less investment and therefore explains why economic growth is lower than consumer spending.
  • However, over time you would expect lower interest rates to contribute to higher levels of investment; because it is cheaper to borrow for investment. This should benefit general economic growth and not just consumer spending.

3. Exchange Rate.

A strong exchange rate makes exports more expensive and less competitive. Therefore, there is a fall in demand for exports. This harms the manufacturing sector, which relies heavily on exports. Therefore, although consumer spending is rising, other aspects of economic growth like manufacturing output is in relative decline. This explains a lower growth rate. However, the manufacturing sector has been declining as a % of GDP. This makes the economy less dependent upon manufacturing than it used to be. The decline in competitiveness and changing comparative advantage is also exacerbating the decline in the manufacturing export sector.

4. Supply Side Factors.

Domestic demand is rising, but the Productive capacity of the economy may be lagging behind. Therefore, in the long run this will lead to inflation and a balance of payments deficit. Therefore, it is not sustainable for domestic demand to run ahead of economic growth in the long run.

Other factors to consider:

  • Increased availability of credit
  • Changing Comparative Advantage
  • Cost Push factors like rising Oil prices
  • Government spending as a component of AD

1 comment:

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