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The Growth Cycle and the Role of a Central Bank

Brian J. Sullivan
Edina High School
Edina, Minnesota

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 of life.

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 facilities (4).

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.

Works Cited

(1) Smith, Adam. "An Inquiry into the Nature and Causes of the Wealth of Nations."

(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.