Economic Growth

What Is Economic Growth?

Economic growth is an increase in the production of economic goods and services, compared from one period of time to another. It can be measured in nominal or real (adjusted for inflation) terms. Traditionally, aggregate economic growth is measured in terms of gross national product (GNP) or gross domestic product (GDP), although alternative metrics are sometimes used.

Understanding Economic Growth

In simplest terms, economic growth refers to an increase in aggregate production in an economy. Often, but not necessarily, aggregate gains in production correlate with increased average marginal productivity. That leads to an increase in incomes, inspiring consumers to open up their wallets and buy more, which means a higher material quality of life or standard of living.

In economics, growth is commonly modeled as a function of physical capital, human capital, labor force, and technology. Simply put, increasing the quantity or quality of the working age population, the tools that they have to work with, and the recipes that they have available to combine labor, capital, and raw materials, will lead to increased economic output.

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There are a few ways to generate economic growth. The first is an increase in the amount of physical capital goods in the economy. Adding capital to the economy tends to increase productivity of labor. Newer, better, and more tools mean that workers can produce more output per time period. For a simple example, a fisherman with a net will catch more fish per hour than a fisherman with a pointy stick. However two things are critical to this process. Someone in the economy must first engage in some form of saving (sacrificing their current consumption) in order to free up the resources to create the new capital, and the new capital must be the right type, in the right place, at the right time for workers to actually use it productively.

A second method of producing economic growth is technological improvement. An example of this is the invention of gasoline fuel; prior to the discovery of the energy-generating power of gasoline, the economic value of petroleum was relatively low. The use of gasoline became a better and more productive method of transporting goods in process and distributing final goods more efficiently. Improved technology allows workers to produce more output with the same stock of capital goods, by combining them in novel ways that are more productive. Like capital growth, the rate of technical growth is highly dependent on the rate of savings and investment, since savings and investment are necessary to engage in research and development.

Another way to generate economic growth is to grow the labor force. All else equal, more workers generate more economic goods and services. During the 19th century, a portion of the robust U.S. economic growth was due to a high influx of cheap, productive immigrant labor. Like capital driven growth however, there are some key conditions to this process. Increasing the labor force also necessarily increases the amount of output that must be consumed in order to provide for the basic subsistence of the new workers, so the new workers need to be at least productive enough to offset this and not be net consumers. Also just like additions to capital, it is important for the right type of workers to flow to the right jobs in the right places in combination with the right types of complementary capital goods in order to realize their productive potential.

The last method is increases in human capital. This means laborers become more skilled at their crafts, raising their productivity through skills training, trial and error, or simply more practice. Savings, investment, and specialization are the most consistent and easily controlled methods. Human capital in this context can also refer to social and institutional capital; behavioral tendencies toward higher social trust and reciprocity and political or economic innovations like improved protections for property rights are in effect types of human capital that can increase the productivity of the economy.

Measured in Dollars, Not Goods and Services

A growing or more productive economy makes more goods and provides more services than before. However, some goods and services are considered more valuable than others. For example, a smartphone is considered more valuable than a pair of socks. Growth has to be measured in the value of goods and services, not only the quantity.

Another problem is not all individuals place the same value on the same goods and services. A heater is more valuable to a resident of Alaska, while an air conditioner is more valuable to a resident of Florida. Some people value steak more than fish, and vice versa. Because value is subjective, measuring for all individuals is very tricky.

The common approximation is to use the current market value. In the United States, this is measured in terms of U.S. dollars and added all together to produce aggregate measures of output including Gross Domestic Product.