Defining Economic Growth
The simplest definition of economic growth is an increase in real gross domestic product (GDP) (that is, GDP adjusted for inflation). The growth rate of real GDP is the percentage change in real GDP from one year to the next. We can express the rate of growth in, for example, the period 2004-2005, as follows:
- Growth rate of GDP = [GDP(2005) - GDP(2004)]/ GDP(2004) × 100
U.S. real GDP in 2004 was 10.76 trillion and in 2005 it was 11.13 trillion. Thus the growth rate of real U.S. GDP from 2004 to 2005 was
- (11.13 – 10.76) / 10.76 = (0.37) / 10.76 = 0.034 or 3.4%
For purposes of evaluating how economic growth can feed into economic development it is often helpful to focus on the growth rate of GDP per capita—that is, output per person—rather than simply on overall output. Mathematically, GDP per capita is expressed as:
- GDP per capita = GDP / Population
The growth rates of GDP, population, and GDP per capita are related in the following way:
- Growth Rate of GDP = Growth Rate of Population + Growth Rate of GDP per capita
- Growth Rate of GDP per capita = Growth Rate of GDP – Growth Rate of Population
|Figure 1: Economic Growth in the ADE/ASR model. Economic growth increases the maximum capacity of the economy. It involves both supply-side and demand-side expansions, and does not necessarily involve a change in the rate of inflation (Source: GDAE)|
Thus, for example, an economy that has a GDP growth rate of 4% and a population growth rate of 2% would have a per capita GDP growth rate of 2%. The per capita GDP growth rate is especially important because it indicates the actual increase in average income being experienced by the people of the country. If a country had a 2% GDP growth rate, but a 3% population growth rate, its per capita GDP growth rate would actually be negative, at -1%. The people would on average be getting poorer each year, even though the overall economy is growing. A more positive way of putting it is that, for people’s incomes on average to increase over time, the GDP growth rate must exceed the rate of population growth.
In terms of the Aggregate Supply and Demand (ASR/ADE) graphs, economic growth can be shown as a rightward shift of the ASR, increasing the economy’s maximum capacity (Figure 1). If this kind of increase in aggregate supply took place without any shift in ADE, its effects would include growth in output and a declining rate of inflation. In practice, however, economic growth is usually accompanied by, and at least in part is often caused by, an increase in aggregate demand. Thus a more typical pattern for economic growth would be for both the ADE and ASR curves to shift to the right. In this case output clearly rises, but the effect on inflation is ambiguous.
What causes economic output to increase? One way that output can increase is if there is an expansion in the inputs used to produce it. There are five kinds of capital. Human-produced capital is called manufactured capital to distinguish it from the other kinds of capital. Land and natural resources are natural capital, and all the skills and knowledge possessed by humans are also a kind of capital – human capital. We also note the importance of social and financial capital, which both refer to institutional arrangements that make production possible.
Economists sometimes think about output as being generated according to a "production function," which is a mathematical relation between various inputs and the level of output. In the most general sense we might say that the output of an economy should be expressed as a function of flows from all the different types of capital that make production possible. The inputs to the production function are commonly referred to as factors of production. In the production functions most commonly used by economists, the factors that are emphasized are manufactured capital and labor. Sometimes, but not always, natural resources also are included.
One very influential, and more specific, model of economic growth was developed by economist Robert Solow in 1957. In his model, he assumed that an economy-wide production function can be written in the simple form:
- Y = A K0.3 L0.7
where Y is aggregate output, A is a number based on the current state of technology as described below, K is a quantitative measure of the size of the stock of manufactured capital, and L the quantity of labor used during the period of time. K and L are the only factors of production explicitly included in the model. Both capital and labor are needed for the production of output, with the exponents in the equation reflecting their relative contributions.
A is called total factor productivity, and includes all contributions to total production not already reflected in levels of K and L. Often, “total factor productivity” has been interpreted as reflecting the way in which technological innovation allows capital and labor to be used in more effective and valuable ways. For example, the development of computer word-processing greatly increased efficiency compared to the use of typewriters. Typewriters, which seem antique to us today, were themselves a huge productive advance over clerical work using pen and paper. This process of improved technological methods has resulted in an increase in labor productivity – more output can now be produced with fewer labor-hours.
After some mathematical manipulations, the production function above can be converted to an equation for the growth rate of output per worker as a function of “total factor productivity” and the growth rate of manufactured capital per worker:
- growth rate of output per worker = growth rate of total factor productivity + 0.3 (growth rate of manufactured capital per worker)
For example, if “total factor productivity” grows at 1% per year and capital per worker grows at 2% per year, this equation says that output per worker will grow at 1.6% per year (1% + (0.3)2% = 1.6%). This became known as the “growth accounting” equation.
Note that output per worker is what is commonly referred to as “labor productivity”. While labor productivity and GDP per capita are not quite equivalent (some people in the population do not work, for example), they are obviously closely related. Thus, this model implies that the way to raise income per capita—to achieve economic growth—is to increase the amount of capital that each person works with (the second term) and improve technology (the first term).
The use of the Solow growth model served to highlight some important factors in economic growth. In particular, the model led to much discussion of the role of savings in providing the basis for growing levels of manufactured capital per worker. Technological change also received attention, since this was thought to be the main driver behind growth in the value of "A." For many years, economists tended to treat growth as primarily a matter of encouraging savings, investment, and the creation and dissemination of technology.
In more recent years, other economists have suggested that perhaps this model has directed too much attention to savings and technology. Some have argued that other factors such as good institutions that support markets, innovations in the organization of work, or access to global markets should be thought of as equally important in promoting economic growth. It is not helpful, they suggest, to fold all issues of social, human, financial and natural capital into just one, rather vague, "A" term.