The Growth Cycle and the Role of a Central Bank
Brian J. Sullivan
Edina High School
As defined by Adam Smith in his book The Wealth of Nations,
the wealth of a nation is "the fund which originally supplies [a nation]
with all the necessaries and conveniences of life which it annually consumes..."
(source 1). Growth in a nation's wealth relies on a variety of frequently
investigated factors, including investment, production and expectations.
If applied correctly, investment can augment the quality and quantity
of production by providing means to produce more efficiently, as well
as providing means for distribution and allocation. Accompanying the growth
in production is an improved view of the economy, reflected in a society's
expectations. These enhanced expectations can both draw investment into
the economy and give a feeling of security regarding the future, two factors
necessary for successful growth. The combination of the three factors
of investment, production and expectations creates a cycle that, once
started, can compound a nation's growth and raise the overall standard
of living. Crucial to the success of this cycle is the presence of a national
bank. Guiding the flow of money, a bank can be a very powerful force in
the cycle by allocating funds to their most useful application. It can
also be a catalyst to the cycle by beginning the flow of investment with
the manipulation of the money supply. The growth of a nation can be expressed
with the cycle of investment, production and expectations, and with the
help of a national bank, can provide a means of improving a nation's quality
The economic growth of a country can be expressed with the cycle shown
at left, representing the development of an economic system. This approach
allows one to look at the impacts of simplified inputs and give a basic
understanding of the system. Investment, often the first step in the cycle,
provides a base on which a nation can develop. Its most important effect
is that it allows for the production or purchase of capital, means to
facilitate the production of a good, which is required for the long-term
growth of a nation (3). One such form of capital is human capital
and is defined as the "knowledge and skills that workers acquire through
education, training and experience" (6). The first step in strengthening
the quality of human capital is providing a strong education. By educating
a nation's people, a more effective workforce can be created, leading
to improved production. Physical capital, composed of the equipment
and structures used to produce a good, is the other form of capital necessary
to a growing economy. Physical capital is complementary to human in production,
and can make the production process more efficient (2). By investing in
physical capital, output per worker can increase, thus raising the overall
productivity of a nation. Perhaps the most vital form of physical capital
to a developing economy is infrastructure, including means of storage
and transport. Evidence of this necessity can be seen in the Great Depression,
a time when many people around the world were starving due to a lack of
food, but at the same time crops were rotting in fields because transportation
was either too expensive or nonexistent. Without adequate transportation,
a nation could be producing enough goods to supply its needs, though be
unable to distribute those goods to regions where they are needed. Also,
with proper storage facilities, a surplus in goods could be stored and
saved for future use. The availability of stored goods in a time of need
can be crucial to a developing nation, and can be assured with the proper
If investment funds have been made available and put toward beneficial
uses, the next step in the cycle will become evident: an increase in the
quality and quantity of production. For instance, investment funds may
be spent toward the construction of a new or improved factory, which would
aid in the production of a product. Investment in the infrastructure of
a nation can allow producers to pursue a surplus in goods, which could
be sold in more distant domestic markets, or even foreign markets. This
pursuit of surplus can be very beneficial to a society in the sense that
producers will seek efficient methods of production, leading to economies
of scale (4).
Completing the cycle is the idea of expectations. A population's expectations
on various aspects of the economy can determine how well growth can be
maintained in the long run. Population expectations are a particularly
vital realm, because in order for growth to be successful, it must be
embraced by the people that it involves. For this to occur, the members
of a society must exhibit deferred gratification pattern. This involves
a future-minded emotion in the society, which is important for three reasons.
One of these is that a future-minded society is much more likely to save
a portion of its income. With these savings, businesses will be more able
to invest because of the increase in available funds (6). The second reason
is that a future-minded society will tend to develop health standards,
and by doing so is able to invest in its own human capital, ensuring an
experienced workforce. Finally, the third reason is that a future-minded
society is more likely to understand the benefits of education. Education
allows a nation's workforce to advance, thus enhancing its productivity.
If the benefits of proper education can be embraced by a society, people
will pass up general labor jobs in the hopes of earning more in a skilled
position later in life (4).
The second portion of expectations is that of the economy. In order
to maintain long-term growth, people must feel that the economy is relatively
stable. The population must feel its stability in order to save, aiding
domestic investment, but more importantly. other nations must sense the
economy's stability. Foreign investors are much more likely to invest
in an economy that exhibits a general growth and is free from high or
fluctuating inflation. If a developing economy is able to exhibit economic
stability, foreigners could look to the nation as an outlet for investment
funds. Thus, the investments caused by population and economic expectations
complete the cycle of growth.
The existence of a central bank can have profound effects on the growth
cycle if it uses its power in constructive ways that benefit society as
a whole. Working together with a stable central government, a bank can
guide the growth of a nation by creating and allocating funds. A bank,
however, has the difficult task of balancing both interest rates and inflation,
a task which, if done correctly, can aid in the growth of a nation. One
way to assist growth is through a managed expansion of the money supply,
accompanied by a decrease in interest rates. Due to the increased accessibility
of funds, a society would be more likely to invest. With this increase
in investment, capital production and purchase would rise, and the cycle
would continue, expanding the economy. If not done carefully, however,
a bank's expansion of the money supply could raise inflation rates. The
resulting increase in inflation would tend to slow growth because real
investment returns would be diminished due to the decrease in real value
of the currency. With a smaller return, both foreign and domestic investors
would tend to seek out other investment opportunities yielding higher
returns. If a bank can promote a low interest rate while keeping inflation
in check, an environment supportive to economic growth can be maintained.
A central bank also has some power to affect expectations. By encouraging
investment with a lowered interest rate, a bank is able to show confidence
in the market by assisting entrepreneurs in the development of businesses.
For this to be effective, though, funds must be distributed without discrimination.
The discrimination in loaning practices was addressed in the United States
with the Community Reinvestment Act, which required loan portfolios of
banks to display diversity among recipients, consisting of a wide demographic
range. Seeing this government initiative, public sentiment towards the
growing economy will tend to improve, leading to increased consumer confidence.
Seeing this confidence, foreign investors would also become more likely
to invest, allowing businesses to grow even further. Finally, by making
funds available to all sectors of the economy, a bank can guarantee development
throughout the entire system, important to the growth of a nation.
The factors contributing to the development of a nation's economy, though
complex, can be seen in the cycle of investment, production and expectation.
First, through investment, a nation can create an infrastructure and build
up a stock of capital, two key components in economic growth. The resulting
increase in production gives a society a feeling of success, which can
lead to positive expectations of the economy. With positive expectations,
people are more likely to invest in an economy, and thus the cycle is
continued. A central bank, with the help of a stable governing system,
can provide help to the cycle by maintaining a steady rate of inflation,
and using monetary policy to ensure investment and stimulate consumer
expectations. By adjusting the money supply, a bank can manipulate both
interest rates and inflation, providing an economic base on which to grow.
The difficulty that banks face. though, is the fine balance that is found
between inflation and interest rates, and the ability to deal with this
difficulty can be a determining factor to a nation's success in growth.
(1) Smith, Adam. "An Inquiry into the Nature and Causes of the Wealth
(2) Canadian Department of Foreign Affairs and International Trade:
"Beyond the Neoclassical Growth Model: Other Factors Behind Economic Growth."
(3) Humpage, Owen F., "Monetary Policy and Real Economic Growth."
Economic Commentary, Federal Reserve Bank of Cleveland. December 1996.
(4) USAID Strategies: "Economic
Growth and Trade."
(5) McConnell, Campbell R., and Stanley L Brue. Economics. McGraw-Hill Inc., 1996.
(6) Mankiw, Gregory N., Principles of Economics. The Dryden
Press, Harcourt Brace College Publishers, 1998.
(7) 1993-1994 Federal Reserve Essay Contest Resource Packet: Lending
Discrimination and the Community Reinvestment Act.