Summary of key points

• Economic growth is the increase in the production of goods and services in an economy.
• Increases in capital goods, labour, technology and human capital all contribute to economic growth.
• Tax cuts are generally less effective at stimulating economic growth than increases in government spending.
• Economic growth is usually measured as the increase in the total market value of additional goods and services produced, using estimates such as GDP.

Understanding economic growth

Simply put, economic growth refers to an increase in total output in an economy, usually expressed as an increase in national income.

Typically, but not necessarily, an increase in total output is associated with an increase in average marginal productivity. This leads to increased incomes, incentives for consumers to open their wallets to buy more goods, and drives higher material quality of life and living standards.

In economics, growth is typically modeled as a function of physical capital, human capital, labor, and technology. Increasing the quantity or quality of the working-age population, the tools available to them, and the recipes available to them for combining labor, capital, and raw materials will result in an increase in economic output.

Stages of economic growth

Economic activity goes through different periods. This movement is called a "business cycle." It consists of four stages:

• Expansion: During this phase, employment, income, industrial production, and sales all increase, and real GDP also rises.
• Peak: This is when the economic expansion reaches its peak. It was actually a turning point.
• Contraction: In this stage, all elements of expansion begin to decrease. When a large decline in economic activity spreads throughout the economy, it becomes a recession. -Trough: This is when the economic contraction reaches its lowest point.

A complete business cycle is calculated from peak to peak or trough to trough. Such cycles are often of irregular length, and there may be periods of contraction during expansion and vice versa.

Since World War II, the U.S. economy has experienced more periods of expansion than contraction. Between 1945 and 2019, the average expansion lasted about 65 months, while the average contraction lasted just 11 months. However, the Great Recession lasted 18 months from December 2007 to June 2009. This was followed by the longest expansion period on record, lasting 128 months until the onset of the COVID-19 pandemic in 2020. [1]

Note: Governments often try to stimulate economic growth by lowering interest rates, which makes borrowing cheaper. However, this can only last for a while. Ultimately, as will happen in 2022 and 2023, interest rates will need to be raised to combat rising prices and prevent the economy from overheating. [2]

How to measure economic growth

The most commonly used indicator of economic growth is real GDP. This is the total value of all goods and services produced in an economy, adjusted to remove the effects of inflation. There are three different ways to look at real GDP.

• Quarterly growth rate (annualized): This looks at the change in GDP from one quarter to another and then compounds this into an annualized rate. For example, if the change over a quarter is 0.3%, then the annualized rate will be extrapolated to 1.2%.
• Fourth quarter or year-over-year growth: This compares GDP in a single quarter over two consecutive years, expressed as a percentage. Businesses often use it to offset the effects of seasonal changes.
• Average annual growth rate: This is the average of the changes each quarter. For example, if there were four quarters in a year with growth rates of 2%, 3%, 1.5%, and 1%, the average annual growth rate for that year would be 7.5% ÷ 4 = 1.875%.

Note: GDP is the most popular way of measuring economic growth and is calculated by adding up all spending by consumers, businesses, and governments in a given period. The formula is: GDP = consumer spending + business investment + government spending + net exports.

Of course, measuring the value of goods is tricky. Some goods and services are considered more valuable than others. For example, a smartphone is more valuable than a pair of socks. Growth must be measured in terms of value of goods and services, not just quantity.

Another problem is that not everyone places the same value on the same goods and services. A heater is more valuable to a resident of Alaska, and an air conditioner is more valuable to a resident of Florida. Some people think steak is more valuable than fish and vice versa.

A common approximation is current market value. In the United States, this is measured in U.S. dollars, and they are summed to produce an overall measure of output, including GDP.

IMPORTANT NOTE: There are alternatives to GDP. For example, the World Bank uses gross national income per capita (including income sent back by citizens abroad) to measure economic growth, analyze countries, and determine their eligibility for borrowing. [3]

How to generate economic growth

Economic growth depends on the following four areas of contribution:

The first is an increase in the quantity of physical capital goods in the economy. Adding capital to the economy tends to increase the productivity of the workforce. Newer, better, and more tools mean workers can produce more output per time period.

To give a simple example, a fisherman with a fishing net can catch more fish per hour than a fisherman with a fishing rod. However, there are two key points to this process.

Someone in the economy must first make some form of saving in order to free up resources to create new capital. Furthermore, the new capital must be of the right type, in the right location, and activated at the right time so that workers can actually use it productively.

The second way to generate economic growth is through technological improvements. The invention of gasoline fuel is one example. Before its energy-generating capabilities were discovered, oil had relatively little economic value. This changed when the use of gasoline proved to be a more efficient method of transporting goods.

Improved technology enables workers to produce more output from the same stock of capital goods by combining them in more efficient ways. Like capital growth, technological growth rates are highly dependent on savings and investment rates as they are necessary to engage in R&D.

Note: The four factors of production are land and natural resources, labor, capital equipment, and entrepreneurship.

Another way to generate economic growth is to increase the labor force. All things being equal, more workers produce more economic goods and services.

In the 19th century, the United States' strong economic growth was partly due to the influx of cheap, efficient immigrant labor. However, as with capital-driven growth, there are some key conditions to this process. [4]

Increasing the labor force necessarily increases the amount of output that must be consumed in order to provide basic survival for the new workers, so the new workers need to be at least productive enough to offset this and not be net consumers.

Furthermore, just like increasing capital, it is important that the right types of workers flow to the right jobs, in the right places, and combined with the right types of complementary capital goods in order to realize their productive potential.

The final approach is to increase human capital. This means workers become more skilled at their craft, increasing their productivity through skills training, trial and error, or simply more practice. Saving, investing, and specializing are the most consistent and easily controllable methods.

In this context, human capital can also refer to social and institutional capital. Social behavioral tendencies toward greater social trust and mutual benefit, as well as political or economic innovations, such as improved protection of property rights, are types of human capital that can increase economic productivity.

Why is economic growth important?

Simply put, economic growth means more people will have more stuff, which is why governments try to create it. However, it’s not just about money, goods and services. Politics also enters the equation. How to use economic growth to promote social progress is crucial.

According to research conducted by the United Nations University-World Institute of Development Economics, “most countries that have succeeded in reducing poverty and increasing access to public goods have based this progress on strong economic growth.” However, the institute notes that growth will not be sustainable if benefits flow only to an elite group. [5]

How do taxes affect economic growth?

Taxes affect economic growth, at least in the short term, through their effect on demand. Tax cuts increase demand by raising disposable income for individuals and encouraging businesses to hire and invest. However, the size of the impact depends on the strength of the economy. If the economy is operating near full capacity, the impact is likely to be minimal. If the economy is operating well below its potential, the effects will be more pronounced. The Congressional Budget Office (CBO) estimates that the impact in the latter scenario is three times greater than in the former. [6]

CBO also found that tax cuts are generally less effective than increasing government spending in stimulating economic growth. This is because most spending stimulates demand, and tax cuts stimulate both savings and demand. One way to mitigate this impact is to target tax cuts at low- and middle-income households, which are less likely to put money into savings. [6]

What is another word or term for economic growth?

Other words and terms for economic growth include "prosperity," "economic development," "economic upswing," "economic upsurge," "industrial development," and "economic vitality."

Conclusion

Economic growth occurs when the production of goods and services increases during a specific period compared to the previous period. It is usually measured as GDP and is an indicator of a country's economic health. However, the extent to which the fruits of growth are widely shared is an important factor in its sustainability, not to mention social health and progress.

References

[1] Congressional Research Service. "Introduction to U.S. Economy: The Business Cycle and Growth," Page 2.

[2] Board of Governors of the Federal Reserve System. "Open Market Operations."

[3] The World Bank. "Methodologies."

[4] U.S. Library of Congress. "U.S. History Primary Source Timeline."

[5] United Nations University World Institute for Development Economics Research. "Why Should I Care About Economic Growth?"

[6] Urban Institute & Brookings Institution Tax Policy Center. "How Do Taxes Affect the Economy in the Short Run?"

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