Economic growth refers to an increase in output in an economy 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 the potential output that can be produced by an economy.
Why is economic growth significant?
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 variety of products and services to meet needs. Therefore, through economic growth, our standard of living will be better.
As the economy grows, more businesses make a profit. Investors in the stock market are becoming more optimistic about their stock prices. Business confidence increases, encouraging them to create more jobs and absorb more workers. It results in a decrease in the unemployment rate.
Households are becoming more optimistic about their work and income. As a result, they can consume more goods and services.
Short term and long term growth
Economic growth data that you often see on various websites or newspapers are 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 (or 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 potential output in an economy. An increase in potential GDP shows that the economy can increase production without affecting the price level. The productive capacity of an economy increases when the supply of factors of production, such as labor and capital increases. Also, the quality factor of human resources and technology is essential in increasing productivity and production capacity.
Measuring the rate of economic growth in the short run
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 bureau in various countries use GDP more often than GNP.
Nominal GDP vs. Real GDP
There are two types of GDP reports nominal GDP and real GDP. Calculation of nominal GDP uses 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.
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. The business began to reduce production and began to 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 with a small percentage, it can have a significant effect on the standard of living of a country’s population. 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 growth in real GDP per capita is associated with environmental damage and low consumption (high savings).
Key determinants of economic growth
Various factors affect economic growth. To sort out the factors, let’s once again, we distinguish between growth in the short run and the long term.
Growth in the short term
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 will stimulate the economy to produce more and utilize intensively its production capacity. 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. The government can cuts taxes or increase its spending to stimulate economic growth. For example, lowering taxes will increase disposable income of the household, thereby encouraging their spending on goods and services.
- Expansionary monetary policy. Monetary authorities or central banks can take various policies to encourage higher economic growth. Among them are cutting policy rates, conducting an open market operation by buying government securities, and lowering reserves requirement.
- Exchange rate depreciation. Depreciation makes domestic goods prices cheaper for foreigners. It will make 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 represents an increase in production capacity of the economy. 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
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 the supply of factors of production in a country. 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.
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.
Advances in technology enable the economy to be more productive. In a sense, even though factors of production such as capital and labor 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.
Raw materials, such as oil and land, are essential inputs for production. Hence countries with abundant natural resources should achieve high level of economic growth.
What to read next
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- Unemployment Rate: Formula, Types, Causes, and Effects
- Balance of Payment: Meaning, Formula, Component, Importance
- Economic Growth: Factors, Importance, Impacts, How to Measure It
- Income Distribution: How to Measure and Overcome Inequality
- What are the 5 macroeconomic objectives
- Possible Conflicts Between Macroeconomic Objectives
- Economic Development: Meaning, Goals, and Stages
- Economic Growth and Economic Development: Their Differences and Relationships