Economic growth is an increase in the amount of goods and services produced per head of the population over a period of time.
The total value of output of goods and services produced is known as the national output. This can be calculated in three ways: using output, income or expenditure.
GDP (Gross Domestic Product): the total market value of all final goods and services provided within an economy by its factors of production in a given period of time.
Nominal GDP: the value of output produced in an economy in a period of time, measured at their current market values or prices is the nominal GDP.
Real GDP: the value of output produced in an economy in a period of time, measured assuming the prices are unchanged over time. This GDP, in constant prices, provides a measure of the real output of a country.
GDP per head/capita: this measures the average output/ income per person in an economy. Since this takes into account the population, it provides a good measure of the living standards of an economy.
GDP per capita = GDP / Population
An increase in real GDP over time indicates economic growth as goods and services produced have increased. It indicates that the economy is utilizing its resources better or its productive capacity has increased. On a PPC, economic growth will be shown by an outward shift of the PPC, which is also called ‘potential growth’. ‘Actual growth’ occurs when the economy moves from a point inside the PPC to a point closer to the PPC.
Causes of economic growth
- Discovery of more natural resources: more resources mean more the production capacity. The discovery of oil and gas reserves have enabled a lot of economies (Norway, Saudi Arabia, Venezuela etc.) to grow rapidly.
- Investment in new capital and infrastructure: investment in new machinery, buildings, technology etc. has enabled firms and economies to expand their production capacities. Investment in modern infrastructure such as airports, roads, harbours etc. have improved access and communication in economies, helping in achieving quicker and more efficient production.
- Technical progress: New inventions, production processes etc. can increase the productivity of existing resources in industries and help boost economic growth.
- Increasing the quantity and quality of factors of production: A larger and more productive workforce will increase GDP. More skilled, knowledgeable and productive human resources thus help increase economic growth. Similarly, good quality capital, use of better natural resources, innovative entrepreneurs all aid economic growth in the long run.
- Reallocating resources: Moving resources from less-productive uses to more-productive uses will improve economic growth.
The benefits of economic growth:
- Greater availability of goods and services to satisfy consumer wants and needs.
- Increased employment opportunities and incomes.
- In underdeveloped or developing economies, economic growth can drastically improve living standards and bring people out of poverty.
- Increased sales, profits and business opportunities.
- Rising output and demand will encourage investment in capital goods for further production, which will help achieve long run economic growth.
- Low and stable inflation, if growth in output matches growth in demand.
- Increased tax revenue for government (as incomes and spending rise) that can be invested in public goods and services.
The drawbacks of economic growth:
- Technical progress may cause capital to replace labour, causing a rise in unemployment. This will be disastrous for highly populated underdeveloped and developing economies, pulling more people into poverty
- Scarce resources are used up rapidly when production rises. Natural resources may get depleted over time.
- Increasing production can increase negative externalities such as pollution, deforestation, health problems etc. Climate change is a consequence of rapid global economic growth.
- If the economy produces over its productive capacity and if the growth in demand outstrips the growth in output, economic growth may cause inflation
- Economic growth has also been accused of widening income inequalities in developing economies, because rich investors and businessmen gain more than the working class and poor during growth – the benefits of growth are not evenly distributed. This will cause relative poverty to rise.
Governments aim for sustainable economic growth which refers to a rate of growth which can be maintained without creating significant economic problems for future generations, such as depletion of resources and a degraded natural environment.
Recession is the phase where there is negative economic growth, that is real GDP is falling. This usually happens after there is rapid economic growth. High inflation during the boom period will cause consumer spending to fall and cause this downturn. Workers will demand more wages as the cost of living increase, and the price of raw materials will also rise, leading to firms cutting down production and laying off workers. Unemployment starts to rise and incomes fall.
Causes of recession:
- Financial crises: if banks have a shortage of liquidity, they reduce lending and this reduces investment.
- Rise in interest rates: increases the cost of borrowing and reduces demand.
- Fall in real wages: usually caused when wages do not increase in line with inflation leading to falling incomes and demand.
- Fall in consumer/business confidence: reduces both supply and demand.
- Cut in govt. spending: when government cuts spending, demand falls.
- Trade wars: uncertainty in markets, and thus businesses will be reluctant to invest during a trade war, causing supply to fall.
- Supply-side shocks: e.g. rise in oil prices cause inflation and lower purchasing power.
- Black swan events: black swan events are unexpected events that are very hard to predict. For example, COVID-19 pandemic in 2020 which disrupted travel, supply chains and normal business activity, as well consumer demand, has caused recessions in many countries.
Consequences of recession:
- Firms go out of business: as demand falls, firms will be forced to either reduce production to a level that is sustainable or close shop.
- Unemployment: cuts in production will cause a lot of people to lose work.
- Fall in income: cuts in production also causes fall in incomes.
- Rise in poverty and inequality: unemployment and lack of incomes will pull a lot of people into poverty, and increase inequality (as the rich will still find ways to earn).
- Fall in asset prices (e.g. fall in house prices/stock market): recessions trigger a crash in the stock markets and other asset markets as investors’ and consumers’ confidence in the well-being fall of the economy during a recession. The shares owned by investors will be worth less.
- Higher budget deficit: due to falling consumption and incomes, the government will see a fall in tax revenue, causing a budget deficit to grow.
- Permanently lost output: as firms go out of business and employment falls, it results in a permanent loss of output, as the economy moves inwards from its PPC.
Policies to promote economic growth
Expansionary fiscal and monetary policies (demand-side policies) and supply-side policies described in the previous sections can be employed to promote economic growth, depending on the nature of the problems that are holding back the economy from growing. For example, if it is the poor quality of human capital (labour) that is preventing the economy from achieving its maximum productive capacity, the government should invest in education and vocational training centres to improve the quality of the labour force and increase productivity. If it is a lack of effective demand causing slow growth, the government should focus on cutting income taxes, indirect taxes and interest rates to boost spending.
Effectiveness of such policies:
- Demand-side policies that increase the rate of growth above the long-run trend rate will cause inflation and quickly lead to a recession if not controlled.
- Supply-side policies can take considerable time to take effect. For example, if the government invested in better education and training, it could take several years for this to lead to higher labour productivity.
- In a recession, supply-side policies won’t solve the fundamental problem of deficiency of aggregate demand. Increasing the flexibility of labour markets and encouraging investment may help to some extent, but unless there is sufficient demand, firms will be reluctant to increase production and make new investments.
Notes submitted by Lintha
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2 thoughts on “4.6 – Economic Growth”
Can you add the formulas for the gdp part, its not there in the textbook and its driving me crazy 🙂
Nominal GDP = C + I + G + (X – M) or GDP = private consumption + gross investment + government investment + government spending + (exports – imports)
Real GDP = Nominal GDP/GDP Deflator
GDP/Capita = Nominal GDP/Population