What Is Economic Growth?

Economic growth is an increase in the production of economic goods and services in one period compared to a previous period. It can be measured in nominal or real terms. Aggregate economic growth is traditionally measured in terms of gross national product (GNP) or gross domestic product (GDP) but alternative metrics are sometimes used.

Economic development implies an improvement in economic welfare through higher real incomes and other welfare indices such as improved literacy, better infrastructure, reduced poverty and better health care.

Economic development requires a degree of political stability, investment and mixture of public and private initiatives to increase economic potential. Factors influencing the economic future include productivity and innovation, which are driven by education, research, and technological adoption; demographics like population growth and aging; macroeconomic policies such as interest rates, inflation, and government spending; institutional strength, including rule of law and efficient financial systems; and global events such as geopolitical conflicts, climate change, and pandemics.  

Here’s a breakdown of key factors:

Economic Fundamentals

• Land (Natural Resources): This includes all the raw materials provided by nature, such as minerals, land, water, and forests. The availability and quality of these natural resources are crucial for a nation’s economy. 
• Labor (Human Resources): This refers to the human input in the production process, encompassing the quantity of workers as well as their skills, education, training, and overall abilities. Investing in human capital through education improves the quality of the workforce. 
• Capital (Capital Formation): Capital refers to the man-made tools and resources used to produce goods and services. This includes machinery, equipment, factories, and infrastructure like roads and technology. Capital formation is the act of investing in these goods. 
• Entrepreneurship: This is the fourth factor of production and involves the individuals who take risks to start new businesses and organize the other factors to create products and services. Entrepreneurs are key to innovation and the growth of new industries and jobs. 

Demographic Trends

• Aging Population: An aging population can strain healthcare and pension systems and affect the labor force, influencing long-term economic stability. 
• Population Growth: A larger population can boost the economy by increasing the labor force and demand for goods and services, but it can also strain resources in countries with limited resources. 

Government Policies

• Levels of infrastructure – e.g. transport and communication. In recent years, economic development in Central Africa has been improved due to increased investment in roads, railways and seaports. Part of this investment has come from Chinese companies who have a vested interest in transporting raw materials from Africa to China.
• Education. Levels and standards of education have a significant influence on labour productivity. Without basic literacy and numeracy, it is difficult for an economy to develop from manual labour to new higher tech industries in the service sector. For example, good levels of education in India have given opportunities for growth in service industries, such as IT and call centres.
• Levels of inward investment. Developing countries that can attract inward investment can see significant growth in development due to higher levels of capital and benefits of attracting multinational companies into their economy. For newly industrialised countries (NICs), inward investment has played a significant role in increasing economic development. For example in 2011, inward investment in Brazil stood at $101bn.
• Levels of savings/capital In growth models, such as Harod Domar, levels of savings and capital are seen as a key factor in determining economic growth. Higher savings enables a virtuous circle of increased investment, higher growth, and therefore, higher savings.

• Monetary Policy: Central bank actions, such as raising interest rates to combat inflation, influence economic activity. 
• Fiscal Policy: Government spending and taxation decisions can stimulate or dampen economic growth by affecting discretionary income and business investment. 
• Trade Policies: Tariffs and trade agreements impact the availability and cost of imported resources, affecting supply chains and consumer prices. 
• Political stability / Law and order. Political stability and the protection of private property was ranked as the most important factors for encouraging firms to invest in developing economies. Any sign of instability increases the economic and personal risk of investing in developing countries.
  

The biggest block to development is prolonged civil unrest/military conflict as this causes investment to dry up and resources to be wasted in unproductive means.

• Macroeconomic stability. Similar to political stability, macroeconomic stability encourages investment and development. This involves low rates of inflation and exchange rate stability. Rapid devaluation can cause capital flight and a decline in growth.
• Labour mobility. Is labour able to move from relatively unproductive agriculture to more productive manufacturing?
• Foreign aid. Targeted aid, can help improve infrastructure and living standards. It can be important for developing economies with low levels of savings and capital investment. Aid depends on how it is used – whether it is tied to trade deals or used to overcome market failure in areas such as education and health care. There is also some criticism of foreign aid that it can influence incentives and
• Regional effects. Economic development is strongly influenced by the development of an economies neighbours. For example, in the 1980s and 1990s, south east Asia showed strong levels of economic growth and development. However, Sub-Saharan African countries experienced very slow growth. This is partly due to the gravity effect – the theory that trade is most profitable and efficient with near neighbours. If a neighbour does well, there tends to be spill over effects, such as increased trade and increased investment.
• Natural resources. Ceteris paribus countries with higher levels of natural resources can use this for economic development. For example, the revenues gained from oil have enabled the Gulf states to develop rapidly gaining high levels of real GDP. For African and Asian countries, raw materials are an important source of revenue and export earnings which enables higher development.
  • However, the link between natural resources and development is not straightforward. One theory suggests raw materials can lead to a ‘resource curse‘ where an economy is stuck in producing primary products with no incentive to diversify the economy. It can also depend on whether natural resources are owned by developing economy and actually filter through to different sections of society.
• Tax rates and levels of corruption – e.g what percentage of tax rates are actually collected and spent on public services. For foreign multinationals, a low tax rate may be important to encourage investment. However, there needs to be a balance as the government need to collect tax to fund public services and public infrastructure.
• Free trade vs protectionism. An important debate in economic development is between the benefits of free trade versus protectionism. Removal of tariff barries can lead to a rise in exports, which contribute towards economic development. Asian countries, such as Korea, Taiwan and China have all benefitted from removal in tariffs. However, for developing economies stuck in producing primary products (where they have static comparative advantage) there is a strong case for temporary tariffs to enable new infant industries to develop.
• Tourism. For developing economies with an attractive climate and environment, tourism can be an important source of foreign earnings and incentive to develop infrastructure and new hotels.

Evaluation – other possible factors that influence economic development

• Culture of entrepreneurship. For example, in the past 20 years, India has seen a shift from a conservative religious society to a more secular society with a greater focus on material improvement.
• Political system. Some argue a Command economy can lead to economic stagnation, e.g. Cuba. China has successfully managed a partial economic shift to free-market based economy (with still political control of Communist Party)
• Regulation/free market system. Free market economists, such as Milton Friedman, argue that the openness of an economy is important. For example, privatization and deregulation reduce barriers to investment and economic growth.

A low-income trap is when an economy gets caught in low growth and struggles to ‘break out’. With low income, savings will be low, leading to low investment and low growth. The economy will focus on commodity exports

Global Events and Stability

• Geopolitical Conflicts: Wars and international tensions create uncertainty, disrupt trade routes, and can impact the availability of resources, affecting economic outlooks. 
• Global Crises: Pandemics, climate change-related events, and natural disasters can have widespread, crippling effects on economies worldwide. 
• Institutions: Strong institutions, including stable legal systems and well-functioning financial markets, foster innovation and long-term economic growth by providing a reliable environment for investment. 

How Economic Growth Works

Economic growth refers to an increase in aggregate production in an economy which generally manifests as a rise in national income.

Aggregate gains in production often but do not necessarily correlate with increased average marginal productivity. This leads to an increase in incomes, inspiring consumers to open up their wallets and buy more and driving a higher material quality of life and standard of living.

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

Phases of Economic Growth

The economy moves through different periods of activity. This movement is referred to as the business cycle. It consists of four phases:

• Expansion: Employment, income, industrial production, and sales all increase during this phase, and there’s a rising real GDP.
• Peak: This is when an economic expansion hits its ceiling. It’s effectively a turning point.
• Contraction: The elements of an expansion all begin to decrease during this phase. It becomes a recession when a significant decline in economic activity spreads across the economy.
• Trough: This is when an economic contraction hits its nadir.

A single business cycle is dated from peak to peak or trough to trough. Cycles generally aren’t regular in length and there can be a period of contraction during an expansion or vice versa.

The U.S. economy has experienced more expansions than contractions since World War II. The average expansion lasted about 65 months from 1945 to 2019. The average contraction was only 11 months. The Great Recession lasted for 18 months, from December 2007 to June 2009. This was followed by the longest expansion on record of 128 months, lasting until 2020 and the advent of the COVID-19 pandemic.

How to Measure Economic Growth

The most common measure of economic growth is real GDP. This is the total value of all goods and services produced in an economy with that value adjusted to remove the effects of inflation. There are three different methods for looking at real GDP:

• Quarterly growth at an annual rate: This looks at the change in the GDP from quarter to quarter which is then compounded into an annual rate. The annual rate would be extrapolated to 1.2% if one quarter’s change is 0.3%.
• Four-quarter or year-over-year growth rate: This compares a single quarter’s GDP from two successive years as a percentage. It’s often used by businesses to offset the effects of seasonal variations.
• Annual average growth rate: This is the average of changes in each of the four quarters. The annual average growth rate for the year would be 7.5% ÷ 4 = 1.875% if there were four-quarter rates of 2%, 3%, 1.5%, and 1% in one year.

Of course, measuring the value of a commodity is tricky. Some goods and services are considered to be worth more than others. A smartphone is more valuable than a pair of socks. Growth has to be measured in the value of goods and services, not just the quantity.

Another problem is that not all individuals place the same value on the same goods and services. A heater is more valuable to a resident of Alaska. An air conditioner is more valuable to a resident of Florida. Some people value steak more than fish.

A common approximation is the current market value. This is measured in terms of U.S. dollars in the United States and is added together to produce aggregate measures of output including GDP.

5 Ways Economic Growth Occurs

Politicians often talk about economic growth and its connection to job creation. But what does “economic growth” actually mean?

Let’s start with the basics. Economic growth occurs when a country’s production capacity increases. In other words, the country’s producers of goods and services are able to make more stuff. In recent years, the U.S. economy has averaged under three percent growth—well behind China, India, and other countries.

The production level can be measured by gross domestic product (GDP), which is the total dollar value of the goods and services produced in a given year. So economic growth actually refers to an increase in GDP, which in turn leads to job creation and more employment. GDP increases in five ways:

1. Rise in labor participation: When the number of people producing goods and services goes up—often due to a population increase—an uptick in production generally follows. America’s labor force participation rate hovers around 63 percent—a 40-year low—one explanation for the country’s lackluster economic growth.
2. Discovery of new resources: The production of goods and services requires raw materials and other resources. When a new source of raw materials—such as oil or lumber—is discovered, more products are made. In large part because of fracking, the U.S. is now the largest natural gas producer in the world.
3. Increase in labor specialization: When the labor force gains more human capital, including skills and general knowledge, producers gain the tools to make more goods and provide more services. It’s one reason why education reform is so important.
4. New technology: The discovery of new processes, tools, or devices can lead to a huge jump in productivity. For example, the invention of the assembly line sped up the production of automobiles, clothing, and toys. When entrepreneurship results in new discoveries, the whole economy benefits.
5. Increased trade: When people trade their money for goods and services, a mutually beneficial exchange occurs that, when multiplied across the entire economy, increases growth and well-being. Reducing regulation, taxes, and barriers to trade will allow for more exchanges to occur.

How to Generate Economic Growth

Economic growth is dependent on four contributory areas:

Increase in Physical Capital Goods

The first factor is an increase in the amount of physical capital goods in the economy. Adding capital to the economy tends to increase the productivity of labor. Newer, better, and more tools mean that workers can produce more output per period. A fisherman with a net will catch more fish per hour than a fisherman with a rod.

Two things are critical to this process, however. Someone in the economy must first engage in some form of saving to free up the resources to create the new capital. The new capital must additionally be of the right type, in the right place, and activated at the right time for workers to use it productively.

Improvements in Technology

A second method of producing economic growth is through technological improvements. The economic value of petroleum was relatively low before the discovery of the energy-generating power of gasoline fuel. This changed when the use of gasoline proved to be a more productive method of transporting goods.

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 because they’re necessary to engage in research and development.

Growth of the Labor Force

Another way to generate economic growth is to grow the labor force. More workers generate more economic goods and services.

A portion of the robust U.S. economic growth was due to a high influx of cheap, productive immigrant labor during the 19th century. There are some key conditions to this process, however, as with capital-driven growth.4

Increasing the labor force necessarily increases the amount of output that must be consumed to provide for the basic subsistence of the new workers. The new workers have to be at least productive enough to offset this and not be net consumers.

It’s also 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 to realize their productive potential.

Increase Human Capital

The last method is to increase human capital. Laborers become more accomplished 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 can also refer to social and institutional capital. Behavioral tendencies toward higher social trust and reciprocity along with political or economic innovations such as improved protections for property rights are types of human capital that can increase the productivity of the economy.

Why Does Economic Growth Matter?

Economic growth means that more will be available to more people which is why governments try to generate it. It’s not just about money, goods, and services, however. Politics also enter into the equation. How economic growth is used to fuel social progress matters.

“Most countries that have shown success in reducing poverty and increasing access to public goods have based that progress on strong economic growth,” according to research conducted by the United Nations University World Institute for Development Economics Research. The institute noted that the growth would not be sustained, however, if the benefits flow only to an elite group.

How Do Taxes Affect Economic Growth?

Taxes affect economic growth through their impact on demand, at least in the short term. A tax cut increases demand by raising personal disposable income and encouraging businesses to hire and invest.

The size of the effect is dependent on the strength of the economy, however. The effect is likely to be small if it’s operating close to capacity. The impact will be more pronounced if it’s operating significantly below its potential. The Congressional Budget Office (CBO) estimates that the effect is three times larger in the latter case than in the former.

The CBO also found that tax cuts generally aren’t as effective in stimulating economic growth as government spending increases because most of the spending boosts demand. Tax cuts boost savings as well as demand. One way to mitigate this effect is to target tax cuts to lower- and middle-income households that are less likely to put the money into savings.

What Is Another Word or Term for Economic Growth?

Other words and terms for economic growth include “boom,” “prosperity,” “economic development,” “economic upswing,” “economic upsurge,” “industrial development,” and “buoyancy of the economy.”

The Bottom Line

Economic growth occurs when there’s a rise in the production of goods and services for a certain period compared with a previous one. It’s generally measured in terms of GDP and is an indicator of the economic health of a country. How widely the fruits of the growth are shared is an important factor in its sustenance, however, not to mention societal health and progress.