What Is Economic Growth?

What Is Economic Growth?

Let me explain to you what economic growth really means. It's an increase in the production of economic goods and services from one period to the next, and you can measure it in nominal or real terms. We traditionally track aggregate economic growth using gross national product (GNP) or gross domestic product (GDP), though sometimes alternative metrics come into play.

Key Takeaways

Understand this: economic growth boils down to an increase in the production of goods and services in an economy. Factors like boosts in capital goods, labor force, technology, and human capital all play a role in driving it. I've seen that tax cuts are generally less effective than ramping up government spending when it comes to spurring this growth. And remember, we commonly measure it by the rise in aggregate market value of additional goods and services, often through GDP estimates.

How Economic Growth Works

Economic growth is about an increase in aggregate production in an economy, which usually shows up as a rise in national income. These aggregate gains in production often, but not always, link to higher average marginal productivity. This results in increased incomes, prompting consumers like you to spend more, which in turn boosts material quality of life and living standards.

We model economic growth as a function of physical capital, human capital, labor force, and technology. If you increase the quantity or quality of the working-age population, the tools they use, or the methods to combine labor, capital, and raw materials, you'll see higher economic output.

Phases of Economic Growth

The economy goes through different periods of activity, known as the business cycle, with four distinct phases. During expansion, employment, income, industrial production, and sales all rise, along with real GDP. The peak is when this expansion reaches its limit, acting as a turning point. Then comes contraction, where all those elements start to drop, turning into a recession if the decline spreads widely. The trough is the low point of this contraction.

We date a single business cycle from peak to peak or trough to trough. These cycles aren't regular in length, and you might see contractions within expansions or the reverse. Since World War II, the U.S. economy has had more expansions than contractions. From 1945 to 2019, average expansions lasted about 65 months, while contractions averaged just 11 months. The Great Recession ran for 18 months from December 2007 to June 2009, followed by a record 128-month expansion until the COVID-19 pandemic hit in 2020.

Note on Government Stimulation

Governments often try to kickstart economic growth by lowering interest rates to make borrowing cheaper. But this can't go on forever; eventually, rates must rise to fight inflation and prevent the economy from overheating, as we saw in 2022 and 2023.

How to Measure Economic Growth

The standard way to measure economic growth is through real GDP, which is the total value of all goods and services produced, adjusted for inflation. You can look at it in three ways: quarterly growth at an annual rate, which compounds quarterly changes into an annual figure; four-quarter or year-over-year growth rate, comparing one quarter to the same in the previous year as a percentage to offset seasonal effects; or annual average growth rate, averaging the changes over four quarters.

GDP calculation adds up consumer spending, business investment, government spending, and net exports. Measuring value is tricky since not all goods are equal—a smartphone outvalues socks, for instance. We measure growth by value, not just quantity. People value items differently too, like a heater in Alaska versus an air conditioner in Florida. We approximate this with current market value in U.S. dollars to get aggregates like GDP.

Important Alternatives

Alternatives to GDP exist; the World Bank uses gross national income per capita, including remittances from citizens abroad, to measure growth, classify countries, and set borrowing eligibility.

How to Generate Economic Growth

Economic growth relies on four key areas. First, increasing physical capital goods boosts labor productivity—think a fisherman with a net catching more than one with a rod. But this requires saving to free resources and ensuring the capital is the right type, placed correctly, and timed well.

Second, technological improvements drive growth by making better use of existing resources, like how gasoline revolutionized petroleum's value. This depends on savings and investment for research and development.

Third, growing the labor force adds more workers to produce more, as seen with 19th-century U.S. immigration. But new workers must be productive enough to cover their own needs and match the right jobs with complementary capital.

Fourth, increasing human capital means workers get better through training or practice, or through social factors like trust and property rights protections, all enhancing overall productivity.

Why Does Economic Growth Matter?

Economic growth matters because it means more goods and services for more people, which is why governments push for it. But it's not just about economics—politics play in too. How we use growth for social progress is key. Research shows countries reducing poverty and improving public goods access base it on strong growth, but it won't last if benefits only go to elites.

How Do Taxes Affect Economic Growth?

Taxes influence growth by affecting demand short-term. A tax cut boosts disposable income and encourages hiring and investment. The effect varies with the economy's state—small if near capacity, larger if below potential. The CBO says it's three times stronger in the latter case. Government spending is often more effective than tax cuts since it directly boosts demand, while cuts split between demand and savings. Target cuts to lower- and middle-income groups to minimize savings and maximize impact.

What Is Another Word or Term for Economic Growth?

You might hear economic growth called 'boom,' 'prosperity,' 'economic development,' 'economic upswing,' 'economic upsurge,' 'industrial development,' or 'buoyancy of the economy.'

The Bottom Line

In essence, economic growth happens when production of goods and services rises compared to a prior period, measured mainly by GDP as a sign of a country's economic health. But how evenly we share the benefits determines its longevity and contributes to societal well-being.