Economic growth
Economic growth results from increase in production capacity in the market or country, and this growth are measured through Gross Domestic Product. Essentially, economic growth is an increase in actual Gross Domestic product and it is caused by increased aggregate demand and aggregate supply. Aggregate supply refers to productive capacity and its increase is brought about by more labor participation, new resources, and specialization of labor, improved technology and increase in level of trade (Mankiw, 2017). The growth in economy is driven by business capital investment, where the business uses financial capital for investment in capital goods. Increase in capital goods lead to more labor productivity, utilization of resources and higher level of research and development which leads to improved technology. Therefore, long-run economic growth needs more long-term aggregate productivity capacity /supply which are provided through increased business investment (Mankiw, 2017).
The intersection between loanable funds demand and supply in a basic demand and supply graph determines the interest rates. Since businesses are the major loanable funds borrowers, they will only turn to borrowing if they are able to invest in real capital and therefore produce goods or services whose return on investment will be higher than interest rate that is charged on the loanable funds. This means that businesses investment in terms of capital goods will be determined by whether they are able to access the financial capital whose cost is determined by the prevailing interest rates. The supply of loanable fund is higher if the interest rates are high while demand for such funds will be low at such high interest rates (Mankiw, 2017). The Federal Reserve normally manipulate the rates of interact to set the monetary policy, by increasing and decreasing the loanable funds. Decrease in the interest rates induces more buying and this in turn stimulates the country’s economy. An increase in the rate of interest lead to higher borrowing cost, which means that the cost of loanable funds will be high and which leads to reduced incentive for businesses and individuals to invest(Mankiw, 2017). The higher rates also makes the value of currency to increase making the market less competitive and , increases imports and reduces exports and eventually it leads to reduced aggregate demand. The high interest rates affect the confidence level of investors, by making them less willing to carry out risky investments (Mankiw, 2017).
Every year, a deficit in the government budget adds more to sovereign debt of the country. The interest on this debt has to be paid yearly, and as it grows the spending increases without any returns. A high payment on interest brings about slow economic growth, since these funds could have been utilized in stimulating the economy. The yearly rise in interest rates leads to change in loanable funds supply, and an increase in interest rate equilibrium would occur if there is a shift of loanable funds demand to the right and supply to the left.
The conclusion by the McKinsey Global Institute that fiscal sustainability is important for growth of the economy stems from the need for managing government debt which is likely to affect the interest rates and the ability to repay the debt. The increase in fiscal budget may be costly where the government expenditure through debt financing so that it surpasses the spending by the private sector investments which may lead to a raised actual interest rates (Mankiw, 2015).
References
Mankiw, N. G. (2015). Principles of macroeconomics. Cengage Learning. 272-273
Mankiw, N. G. (2017). Brief principles of macroeconomics. Place of publication not identified: Cengage Learning.169-172
