Economic Growth

What is Economic Growth?

Economic growth refers to the sustained increase in a country's production of goods and services over time. It is a central focus in macroeconomics because it determines improvements in living standards and national wealth.

• Rich country: A nation with a high level of wealth at a given time.

• High economic growth: A nation whose wealth is increasing rapidly, regardless of its current wealth level.

• A poor country can experience high economic growth, while a rich country may have low growth.

Example: Country A and Country B may have different levels of wealth and growth rates, illustrating that current wealth and growth are distinct concepts.

Measuring Economic Growth

Growth is typically measured as the annual percentage change in a variable such as real GDP or real GDP per person.

• Growth rate formula:

• Growth rate of real GDP per person:

• Improvement in standard of living occurs only if production increases faster than population.

What Does Real GDP Growth Mean?

There are two main reasons why real GDP might increase from one year to the next:

• Reason 1: The country moves from inside the production possibilities frontier (PPF) to on the PPF (from inefficient to efficient production). This is not true economic growth, but rather a move to full employment.

• Reason 2: The PPF itself expands, meaning the country can produce more than before. This is true economic growth.

Economic growth is defined as the expansion of production possibilities.

The Rule of 70

The Rule of 70 estimates how long it will take for a variable to double, given a constant growth rate:

• Example: If real GDP grows at 10% per year, it will double in about 7 years.

Determinants of Economic Growth

The Four Factors of Production

Economic output depends on four factors: land, labor, capital, and entrepreneurship.

• Land: Generally fixed in the short run.

• Capital and entrepreneurship: Can be increased over time, but not instantly.

• Labor: Can be adjusted in the short run, acting as the 'gas pedal' for the economy.

Potential GDP and the Labor Market

Potential GDP is the value of output when all resources, especially labor, are fully employed. The labor market determines how much labor is used and at what wage.

• Aggregate production function: Shows the relationship between total labor hours and real GDP. Each additional hour of labor adds less to output than the previous hour (diminishing returns).

• Aggregate labor market: The supply and demand for labor determine the equilibrium real wage and employment level.

What Makes Potential GDP Grow?

There are two main drivers of potential GDP growth:

1. Growth of the supply of labor: Increases in the number of hours worked, driven by population growth, higher labor force participation, or longer working hours.

2. Growth of labor productivity: Increases in output per hour worked, driven by better technology, more capital, and improved skills.

Growth of the Supply of Labor

• Population growth increases labor supply, shifting the labor supply curve rightward in the labor market.

• Potential GDP rises, but potential GDP per hour of labor may fall due to diminishing returns.

Growth of Labor Productivity

• Labor productivity:

• When labor productivity rises, the aggregate production function shifts upward, and demand for labor increases.

• Potential GDP rises both because each hour is more productive and because more labor is employed.

What Causes Labor Productivity to Grow?

Labor productivity growth requires certain preconditions and is driven by three main factors:

• Preconditions: Firms, markets, property rights, and money.

• Drivers:

  1. Physical capital growth (more machines and tools)

  2. Human capital growth (more knowledge and expertise)

  3. Technological advances (better ideas and methods)

• Technological change is the most important driver of long-run productivity growth.

Theories of Economic Growth

Classical Growth Theory

Classical growth theory (Malthusian theory) argues that any increase in real GDP per person is temporary because population growth will eventually outpace 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 is assumed to improve at random. Sustained growth in real GDP per person depends on technological progress, as population growth slows and returns to capital diminish.

• Without new technology, long-run growth stalls.

• Technological improvements allow for persistent increases in living standards.

New Growth Theory

New growth theory argues that technological progress is not random but driven by incentives for profit and innovation. Knowledge is a public good, and as long as people seek better lives, new ideas will continue to drive growth.

• Knowledge capital is not subject to diminishing returns.

• Population growth can power economic growth by increasing the number of innovators.

• This theory best fits the evidence of sustained growth in modern economies.

Summary Table: Theories of Economic Growth