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Economic growth refers to an increase in an economy’s output over time. It can be short-term or long-term. In the short run, growth represents an increase in real output, usually seen from changes in real GDP. Meanwhile, in the long run, growth represents an increase in an economy’s potential output.
Why economic growth matters
Economic growth is one of the most widely cited economic indicators. When the economy grows, the number of goods and services increases. As a result, we can access a wider variety of products and services to meet our needs. Therefore, economic growth can improve our standard of living.
Economic growth can also trigger periods of rapid expansion, known as economic boomlets. During these boomlets, several positive effects are amplified:
- Increased profits and investment: As the economy grows, more businesses make a profit. This boosts investor confidence in the stock market, leading to increased investment. A rising stock market can further fuel optimism, creating a positive feedback loop.
- Job creation and lower unemployment: Business confidence increases during economic growth, encouraging companies to create more jobs and absorb more workers. This results in a decrease in the unemployment rate, putting more money into people’s pockets.
- Consumer confidence and spending: During economic growth, households become more optimistic about their work and income security. This translates to increased consumer confidence, leading them to consume more goods and services, further stimulating the economy.
However, it’s important to remember that economic boomlets can also be followed by periods of economic slowdown or recession. Sustainable economic policies are crucial to manage growth and mitigate potential risks.
Short-term vs. Long-term economic growth
Economic growth data that you often see on various websites or newspapers is short-term growth. Short-term growth data is easier to calculate compared to long-term growth.
Changes in real GDP (or constant price GDP) represent economic growth in the short run. When real GDP grows positively, it means the economy is expanding, and vice versa; negative growth means the economy is contracting. Declining economic growth in two consecutive quarters signaled a recession.
Meanwhile, an increase in potential output represents the growth of an economy in the long run. Potential output (sometimes referred to as production capacity) is the maximum amount of production of goods and services. Increased production capacity means that the economy can produce more output.
In macroeconomics, potential GDP represents an economy’s potential output. An increase in potential GDP shows that the economy can increase production without affecting the price level. An economy’s productive capacity increases when the supply of production factors, such as labor and capital, increases. Also, the quality factor of human resources and technology is essential in increasing productivity and production capacity.
Measuring economic growth
Traditionally, there are two statistics to measure the production of goods and services, namely:
GNP measures the market value of the production of goods and services by citizens, regardless of their location, whether they are domestic or abroad. Meanwhile, GDP measures the market value of the domestic production of products and services, regardless of who produces it, whether by foreigners or domestic producers. However, from the two statistics, statistical bureaus in various countries use GDP more often than GNP.
GDP (nominal GDP vs. real GDP)
There are two types of GDP reports: nominal GDP and real GDP. Nominal GDP is calculated using current prices, whereas real GDP uses base-year prices.
When nominal GDP changes over time, it can come from changes in output, prices for goods and services, or a combination of both. In other words, the inflation factor affects changes in nominal GDP.
Meanwhile, changes in real GDP represent changes in the quantity of goods and services produced. Therefore, because economic growth represents an increase in the quantity of output of goods and services, the real GDP is more relevant than the nominal GDP.
Economic growth formula
To calculate the rate of economic growth, we compare the percentage change in real GDP from year to year or quarter to quarter, depending on the type of data reported by the statistical agency.
- Economic growth rate = [(Real GDPt /Real GDPt-1) -1] x 100%
The level of economic growth can be either positive or negative. Positive growth means an increase in the production of goods and services in the economy. We call this economic expansion. Meanwhile, negative growth means a decrease in the production of goods and services. That we call economic contraction.
As the economy expands, consumer and business demand increases. Competitive pressure also tends to fall in line with high demand. Businesses employ more workers to increase production and generate more profits. For the household sector, this is a period where their income prospects are brighter.
Conversely, when the economy contracts, demand for goods and services decreases. Businesses reduce production and rationalize operating costs. If demand falls further, they may lay off workers. Therefore, during this period, the unemployment rate was high. Also, due to low demand, inflationary pressures tend to fade.
Real GDP per capita growth
Economists often use the indicator of real GDP per capita to observe the impact of economic growth on the welfare of a country’s population. Real GDP per capita is calculated by dividing real GDP by the total population. It is the primary indicator of living standards in a country.
When real GDP per capita grows sustainably over time, even by a small percentage, it can significantly affect a country’s population’s standard of living. Although fast growth may be preferred, it is not always sustainable because it is usually accompanied by high inflation, which reduces household purchasing power. Also, high real GDP per capita growth is associated with environmental damage and low consumption (high savings).
Factors Affecting Economic Growth
Various factors affect economic growth. To sort out the factors, let’s once again distinguish between growth in the short run and the long term.
Short-term growth
Short-term economic growth depends on factors that affect short-term macroeconomic equilibrium (real GDP). Real GDP will move along with changes in aggregate demand and short-run aggregate supply.
The change in both will cause the short-run equilibrium to move around potential output (or potential GDP). The movement of real GDP around potential output (whether bigger or smaller) shapes what we call the business cycle. Meanwhile, the gap between real GDP and potential output is called the output gap.
Increased aggregate demand
Aggregate demand will shift to the right, stimulating the economy to produce more and utilize its production capacity intensively. When the demand for goods and services increases, many companies will increase their production.
Aggregate demand will shift to the right when:
- Household wealth increases. The richer the household, the more money they spend. It is known as the wealth effect.
- Consumer confidence improves. When consumers are optimistic about their future income and employment, their spending will tend to increase.
- Business confidence increases. When businesses feel confident about future profits, investment in capital goods will tend to increase.
- Expansionary fiscal policy. To stimulate economic growth, the government can cut taxes or increase its spending. For example, lowering taxes will increase households’ disposable income, thereby encouraging their spending on goods and services.
- Expansionary monetary policy. Monetary authorities or central banks can adopt various policies to encourage higher economic growth. Among them are cutting policy rates, conducting an open market operation by buying government securities, and lowering the reserve requirement.
- Exchange rate depreciation. Depreciation makes domestic goods cheaper for foreigners, making domestic goods more competitive in the international market. As a result, the demand for domestic goods (exports) will increase.
- Global economic growth. Strong global economic growth will increase the demand for domestic goods, thereby increasing exports.
Increased short-term aggregate supply
When the short-term supply shifts to the right, the production of goods and services will increase. In general, short-term supply will increase when production costs get lower. Also, short-term aggregate supply will increase as factors of production increase and become more quality (This is a factor that also affects long-term supply).
The following is a breakdown of short-term aggregate supply drivers:
- Low nominal wages. Wages usually cover a large portion of production costs. When wages are low, production costs are also low and result in increased short-term aggregate supply.
- Raw material prices are lower. As with wages, lower raw material prices reduce production costs and, as a result, increase short-run aggregate supply.
- Lower business tax. When the government lowers taxes on businesses, it reduces production costs and encourages short-term aggregate supply.
- Business subsidies. Higher subsidies reduce production costs, which increases short-term aggregate supply.
- The quantity of production factors increases, and quality increases. When the quantity of factors of production increases, the economy can produce more goods and services. Meanwhile, improving the quality of production factors (more advanced technology, for example), makes higher productivity so that workers can produce more output.
Long-term growth
Long-term growth represents an increase in the economy’s production capacity. When production capacity increases, the economy can produce more goods and services (i.e., potential output, measured by potential GDP).
In macroeconomics, long-term growth is usually modeled as a function of:
- Natural resources
- Labor (human capital)
- Physical capital
- Technology
Short-term aggregate supply and aggregate demand determinants cannot influence long-term growth except for production factors. The source of long-term economic growth is closely related to the quantity and quality of a country’s supply of production factors. In a sense, the economy’s production capacity increases when the supply of factors of production increases, and its quality increases.
Quantity and quality of labor
One way to generate long-term economic growth is to grow the labor force. When there are more workers, the economy can produce more economic goods and services. Several factors affect the number of workers, including population growth, labor force participation rate, and net immigration.
Also, the quality of the workforce is essential. Skilled and educated workers are likely to be more productive, meaning that they produce more output with the given input. They are also better at utilizing technological advancements. We usually refer to the quality of labor as human capital, which represents the accumulation of knowledge and skills acquired by workers from education, training, and experience.
Physical capital
Labor productivity and GDP potential increase along with the higher capital stock. As the Solow growth model shows, output per worker rises when the capital-labor ratio rises. Therefore, increasing the level of investment in physical capital can boost economic growth.
For example, when buying a spinning machine, the manufacturer can produce far more yarn than just manually done. Likewise, when companies switch typewriters to computers, employees can write more articles than before.
Technology
Advances in technology enable the economy to be more productive. Even though factors of production such as capital and labor remain unchanged, more advanced technology makes it possible to produce more output using the same amount of inputs. Thus, technological progress will lead to higher long-term growth.
Natural resources
Raw materials, such as oil and land, are essential inputs for production. Hence, countries with abundant natural resources should achieve high economic growth.
Economic growth models
Economic growth, the expansion of an economy’s output over time, is a complex phenomenon driven by various factors. Understanding these forces is crucial for policymakers and businesses to formulate strategies that promote long-term, sustainable economic prosperity. To delve deeper, let’s explore some key economic growth models:
Harrod-Domar model
The Harrod-Domar model lays the groundwork by emphasizing the role of savings and investment in propelling growth. It suggests a nation’s growth rate is directly linked to its savings rate and the efficiency with which those savings are translated into productive capital (factories, machinery).
Capital deepening expands on this idea. It focuses on increasing the capital-to-labor ratio, meaning equipping workers with better tools and technology. This enhances their productivity, leading to higher output and economic growth.
Solow growth model
The Solow growth model provides a comprehensive framework by incorporating both capital accumulation and technological progress (TFP) as drivers of long-term economic growth. It acknowledges diminishing returns to capital, meaning that simply adding more capital won’t endlessly propel growth. This highlights the importance of continuous innovation and technological advancements for sustained economic expansion. The Solow Growth Model suggests that long-term economic growth comes from a combination of factors, including:
- Increasing the capital stock through savings and investment
- Enhancing human capital through education and training
- Fostering technological innovation to improve efficiency
While capital and labor are crucial inputs, the Solow Growth Model highlights the significance of Total Factor Productivity (TFP). TFP captures the magic that happens when a combination of factors like innovation, better management practices, and technological advancements leads to more output than what can be solely explained by the increase in capital and labor.
Convergence or divergence? the absolute convergence debate
Absolute convergence asks a critical question: Do developing countries eventually catch up to developed ones in terms of economic output? The Harrod-Domar Model and Solow Growth Model suggest this possibility, as long as developing countries have high savings rates and invest in capital and technological advancements. These models imply that developing economies can achieve convergence with developed economies if they can close the gap in capital stock and technological capabilities.
However, reality can be more complex. Factors like institutional weaknesses (such as corruption or lack of property rights) and political instability in developing countries can hinder their ability to converge with developed economies. These factors can discourage investment, both domestic and foreign, and stifle innovation.
Keynesian economics
The models discussed so far focus primarily on the supply side of the economy. Keynesian economics emphasizes the importance of demand in driving growth. During periods of low demand, the government can stimulate the economy through increased spending and investment, putting more money in consumers’ pockets and encouraging businesses to invest. This can help overcome demand-constrained economic situations.
Growing in demand vs. supply-constrained economy
Imagine an economy as a powerful engine. Its ability to grow and produce depends on two key factors: how much fuel it has (resources) and how much demand there is for its output. Economies can be limited by either a lack of fuel (supply-constrained) or a lack of demand for what they produce (demand-constrained).
In a demand-constrained economy, the engine sputters despite having the potential to run much faster. There’s unemployment, factories with extra capacity, and unsold materials. This is because people and businesses simply aren’t buying enough. The good news is that if more demand is injected into the system, the engine can roar back to life, producing more goods and services without prices necessarily increasing. This is in contrast to a supply-constrained economy, where limited resources like oil or labor would cause prices to rise first before any significant increase in output.
Capitalism, for all its strengths, is inherently demand-constrained. It’s like a powerful engine that never runs at full capacity because there’s always a limit on how much people and businesses are willing to buy. Socialist economies, on the other hand, have historically faced the opposite problem: limited resources like skilled workers or raw materials meant they were constantly pushing against their capacity. This challenges the traditional view of capitalism as an “efficient” system. Even if some resources are used well, the whole system is inefficient if a significant portion remains idle due to a lack of demand.
Impacts of economic growth
Economic growth is a cornerstone of a nation’s prosperity. It’s the engine that drives job creation, innovation, and a higher standard of living. But like a double-edged sword, economic growth also presents challenges that need to be addressed. Let’s delve into the sunshine and shadows of a growing economy.
First, we’ll explore the positive impacts of economic growth. A thriving economy brings forth a cornucopia of benefits for both individuals and society as a whole.
- Increased living standards: Economic development, the overall growth and improvement of an economy, drives higher living standards. A growing economy produces more goods and services, offering a wider variety on shelves – from essentials to cutting-edge tech. Imagine limited food choices or outdated electronics – economic development prevents that. By enabling the production of a wider range of goods, it gives people more options to fulfill their needs and desires, leading to a better quality of life.
- Job creation: Businesses thrive in a growing economy, leading them to expand production and hire more workers. This decline in unemployment means more people have jobs, can support themselves and their families, and contribute to the overall economy.
- Investment and Innovation: A growing economy attracts investment. Investors, both domestic and foreign, see a thriving market and are more likely to invest in new businesses and ideas. This fuels innovation, leading to groundbreaking technologies and advancements that benefit everyone.
Limitations of economic growth
However, economic growth isn’t without its downsides. Even as an economy expands, some issues can arise that require careful consideration. Let’s examine the challenges that come with a growing economy.
Income inequality: Economic growth doesn’t always benefit everyone equally. Sometimes, the gains are concentrated among a select few, while others struggle to keep up. This can lead to income inequality, where the rich get richer, and the poor get left behind.
Environmental impact: Our ever-growing hunger for goods and services comes at a cost to the environment. Increased production often means more resource consumption and pollution. Balancing economic growth with environmental sustainability is a critical challenge of our time.
