Economic Growth: Concepts and Measurement

What is Economic Growth?

Economic growth refers to the sustained increase in a country’s production of goods and services over time. Economists seek to understand why some countries experience rapid growth while others do not. Economic growth is distinct from a country’s current wealth; a poor country can grow quickly, and a rich country can grow slowly.

• Rich country: A nation with high current wealth.

• High economic growth: A nation whose wealth is increasing rapidly.

• Growth rate: The annual percentage change in a variable, such as real GDP.

Formula for growth rate:

Growth rate of real GDP per person:

Rule of 70: The number of years for a variable to double is approximately .

Understanding Real GDP and Standards of Living

Real GDP vs. Real GDP per Person

Real GDP measures the total output of an economy, while real GDP per person (per capita) measures the average standard of living. Both are important, but they answer different questions about economic well-being.

• Real GDP: Indicates overall productivity.

• Real GDP per person: Indicates average income and living standards.

Sources of Economic Growth

What Does Real GDP Growth Mean?

Growth in real GDP can occur for two reasons:

• Movement to full employment: The economy moves from inside the production possibilities frontier (PPF) to on the PPF. This is not true economic growth, but rather improved efficiency.

• Expansion of production possibilities: The PPF itself shifts outward, representing true economic growth.

The Role of Labor in Economic Growth

Labor as the "Gas Pedal" of the Economy

Labor is the only factor of production that can be changed quickly in the short run. Increasing labor input can boost real GDP, but only up to the full-employment level.

• Potential GDP: The level of real GDP when all resources are fully employed.

Modeling Labor and Production

Aggregate Production Function

The aggregate production function shows the relationship between the total hours worked and the resulting real GDP. Each additional hour of labor adds less to output than the previous hour (diminishing returns).

Aggregate Labor Market

The aggregate labor market is described by the supply and demand for labor. The real wage rate (wage adjusted for inflation) balances labor supply and demand.

• If the real wage is above equilibrium, there is a surplus of labor (unemployment).

• If the real wage is below equilibrium, there is a shortage of labor.

• At equilibrium, the economy is at full employment and real GDP equals potential GDP.

Determinants of Potential GDP Growth

1. Growth of the Supply of Labor

The total quantity of labor depends on:

• Average hours per worker

• Employment-to-population ratio

• Working-age population

Population growth increases the supply of labor, shifting the labor supply curve to the right. This raises potential GDP but may lower potential GDP per hour due to diminishing returns.

2. Growth of Labor Productivity

Labor productivity is defined as:

When labor productivity rises, more output is produced per hour worked. This shifts the aggregate production function upward and increases the demand for labor, raising both real wages and employment.

Causes of Labor Productivity Growth

Preconditions for Growth

For labor productivity to grow, a country needs:

• Firms

• Markets

• Property rights

• Money

Key Drivers of Productivity Growth

• Physical capital growth: More machines and tools.

• Human capital growth: More knowledge and expertise.

• Technological advances: Better ideas and new ways of doing things.

Technological change is the most significant contributor to long-run productivity growth.

Embodiment of Technology

• Some technologies are embodied in human capital (e.g., mathematical knowledge).

• Most technologies are embodied in physical capital (e.g., computer chips).

Theories of Economic Growth

Classical Growth Theory

Classical growth theory (Malthusian theory) argues that any increase in real GDP per person is temporary. Population growth eventually outpaces resource growth, returning incomes to subsistence levels.

• Key proponent: Thomas Malthus

• Modern-day Malthusians worry about resource limits and environmental constraints.

Neoclassical Growth Theory

Neoclassical growth theory emphasizes the role of technology, which improves at random intervals. Sustained growth in real GDP per person depends on technological progress, as returns to capital investment diminish over time.

New Growth Theory

New growth theory asserts that technological progress results from intentional investment in knowledge, motivated by profit. Knowledge is a public good and not subject to diminishing returns, allowing for permanent economic growth as long as innovation continues.

• Malthusians see population growth as a constraint.

• New growth theorists see population growth as a source of new ideas and innovation.

Summary Table: Theories of Economic Growth