Economic Growth

What is Economic Growth?

Economic Growth is the increase in the quantity of goods and services produced in an economy during a period of time.

The GDP (Gross Domestic Product) measures the value of the goods and services produced during a period of time. The real GDP takes inflation into account, that is, the effects of the inflation are removed.

A positive economic growth means that people has more goods and services to consume or to invest. The economic growth rate is a metric closely watched by economists and analysts, because it’s directly related with the well being of the population.

The economic growth rate is also used to assess the past economic policy of a country: those governments that achieved relatively high growth rate are considered more successful than those that achieved a relatively low economic growth rate.

Economic Growth Rate

To calculate the economic growth rate, we compare the real GDP in one year, with the real GDP in the previous year:

economic growth rate formula

Where:

GDP2 : real GDP in the second period
GDP1 : real GDP in the fist period
ΔGDP: GDP2 - GDP1

Factors of Economic Growth

¿Why, during some periods, is economic growth high while it is low or negative during other periods? ¿Why, some countries like China are able to maintain a high economic growth rate, above 8%, while other countries, like a lot of European countries, have an economic growth rate of near 2% during a long period of time?

Differences in observed economic growth rates can be explained by changes or differences in the factors that govern economic growth in modern economies. The most important factors of economic growth are:

  • Labor Productivity and Education
  • Capital Stock
  • Technology Change

People, Education and Productivity

education as a factor of economic growth

Education increases the efficiency of people and allows the to better use available capital and technology. As education increases, the capacity of the economy to produce goods and services will also increase: education is an important factor of economic growth.

Education not only allows workers to increase their productivity, but also foster the generation of new technologies and innovations and the diffusion of technology in the economy.

Education also influences the efficiency of the public sector, fostering a more efficient government that can provide more and better public goods and services, what in turn impacts in the productivity of the private sector.

Education policy should not be focused only in education that is closely related to economic growth: several studies show that investment in education in sectors like Early Education has a big impact in economic growth.

Capital and Economic Growth

The capital of an economy includes machinery, factories, infrastructure, like ports, roadways, airports, railways, etc. It also includes robots, computers, cars, trucks, etc.

When workers and business have more capital available, they can produce more goods and services.

Investment allows an economy to increase its capital. To increase investment it’s usually necessary to increase savings (usually current savings, or future savings if the economy incurs in indebtment). Several growth models have estimated the optimal savings rate to maximize long term economic growth. The Solow-Swan economic growth model finds out a savings rate that maximizes consumption in the long term. It’s useful to conceptually understand that an effort in the present (lower consumption) can have as a consequence a reward in the future (higher future consumption).

Technological Progress and Economic Growth

Technological Progress is an important factor of economic growth in modern economies. Since the technological explosion of the industrial revolution, economic growth has been higher than in the previous centuries.

Technological progress refers to the process of: Invention, Innovation and Diffusion of the Innovations.

New technologies allows firms to better combine production inputs (like Labor and Capital) to produce more and better goods, or to reduce it’s costs.

This can be illustrated with the following chart:

technology as a factor of economic growth

In the chart we can see two isoquants, T0 with the an old technology, and T1, with a newer technology. Isoquants represent combinations of inputs needed to produce a specific quantity of goods, given a technology. A technological improvement allows the firm to produce the same output, using less inputs. That is seeing by a shift of the isoquant to the left.

While it’s difficult to predict which technological advances will have a big impact in economic growth, currently, we are witnessing important improvements in the sectors of Information and Communication Technologies: artificial intelligence, self driving vehicles and quantum computers will have a big impact in economic growth. Also advances in genetics.

Economic Development and Economic Growth

Although a lot of economists, journalists and politicians use to focus on the economic growth rate when they are assessing the success or fail of economic policies, it should be taken into account that economic growth, as a measure of the welfare change, does not take into account important facts:

  • Economic inequality
  • Environmental pollution
  • Intergenerational transfers of resources, like indebtment or consumption of non renewable natural resources.

The concept of economic development is broader than the concept of economic growth, it’s focused on the welfare of the people and not only in the value of the goods and services (that can be measured). The concept of economic development includes the GDP, but also items like:

  • Income distribution
  • Environmental pollution
  • Access to public goods and services (Parks, Roads, Schools, etc.)
  • Health
  • Education and Literacy
  • Gender Equality
  • Welfare of people that are not in the productive age, like elderly and children.

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