Economic growth

We can see that the United States has experienced faster growth than the United Kingdom since 1950 and we can also see that China has experienced tremendous growth since 1990. It is natural to wonder why. What leads countries to grow faster than others?

Additionally, long term growth is not true for every country. Another question we would like to address is why that is the case?

The broad answer is that it comes down to the growth factors and policies that will be discussed in this subchapter. We will mostly focus on examples that are “success stories” but there are more than a handful of examples of cautionary tales as well.

Benefits of economic growth

Economic growth is generally desirable. Higher real GDP means more goods and services are available, and higher real GDP per capita means higher income and thus higher living standards.

Even though GDP is not a perfect measure of well-being, higher GDP per capita is associated with improved outcomes in health, education and life expectancy.

A final benefit is that higher real GDP provides more opportunity for a government to collect revenue from taxes and thus makes it easier to fund programs.

Thus nearly always one long run policy goal will be to facilitate and encourage economic growth.

Sources of economic growth

To frame our discussion, here are real GDP per capita values for select countries in 1953 and 2022, and their average growth rate over the 69 year period.

Now we can start to answer a couple of key questions. First, what makes some countries richer than others? Second, why do some countries grow faster?

The sources of economic growth are

• Physical capital
• Human capital
• Technology
• Natural resources
• Institutions

The first two sources of growth are capital, which is the general term for resources used in production that are not used up. Physical capital, things like machines, factories and infrastructure, is generated through investment. The exact level of investment is determined in the loanable funds market, which will be discussed in a later subchapter.

Physical capital is not connected to a specific worker or set of workers. However, higher levels of capital per worker, capital deepening, is connected to higher levels of real GDP. The connection to growth is more complicated.

All factors of production generally face diminishing returns. For capital, this means that adding capital alone has a larger return when starting capital is lower compared to when starting capital is higher. Because of this adding capital per worker from a lower starting point can provide a temporary boost to a country’s growth, for example when a country industrializes or otherwise experiences a widespread adoption of new technology. Once a country’s capital per worker is built up, adding further capital has smaller impacts on growth.

This explains why low-income countries may experience higher growth than high-income countries. Looking at China, that is a major factor behind their higher growth over this 69 year period. It is not the only factor, however. We can also see from the table that Chile and Mexico started out poorer and did not experience such high growth.

Human capital refers to the knowledge and abilities of workers. This is linked to the worker and includes things like education, training and even the health of workers. Human capital may increase over time, in which case it should be called experience. But some ideas do wear out over time like physical capital, and require additional training or education to maintain.

Technology generically refers to any changes that allow for more production using the same level of inputs. Thus technological improvements represent a shift in the production possibilities frontier and in the LRAS curve. Technology and productivity are similar at this level, so technology improvements can also be thought of as permanent increases in productivity.

Natural resources covers things that are used up in production and the size of the labor force. Things such as oil, gold, lumber, rare earth minerals, even water and land can enable economic growth and higher levels of real GDP. This is not the most important factor, because resource rich countries include more successful stories like the US, China and Canada as well as less successful stories such as Russia, the Democratic Republic of Congo and Argentina.

A major differentiator between these groups is institutions. This broadly covers legal structure and other societal factors not captured by other categories.

One example of an institutional factor is financial system stability. This is often about the safety of funds in bank or investment accounts and the role of government if such companies do fail. In the United States, since the Great Depression banks have government run deposit insurance up a limit. So if your bank goes out of business, you do not lose your money as it was before this existed.

Economists also look to legal protections for property rights and the rule of law. Stronger property rights encourage investment by making it more likely the benefits are kept by whomever is making the investment. The rule of law refers to predictability and speed of legal processes, so faster and more predictable outcomes are more desirable. Weaker rule of law could also include wider acceptability of bribery, even in government settings, as well as misuse of program funds by government officials.

The Nobel Prize in 2024 was awarded to Daron Acemoglu, Simon Johnson and James A. Robinson for contributions in exploring the relationship between institutions and prosperity. A level-appropriate takeaway about institutions is that good rules do not guarantee growth, but they do make growth more likely.

The aggregate production function

The aggregate production function connects an economy’s inputs to its real GDP. Holding other factors constant, firms need to employ more workers to produce more output, so aggregate employment and aggregate output are directly related. The function also shows that output per person is positively related to both physical capital per person and human capital per person.

Labor productivity is the output of an average employed worker.

$$\begin{array}{r}\text{Labor productivity}=\frac{\text{Real GDP}}{\text{Employed workers}}\end{array}$$

For example, if an economy with 40 million employed workers produces $2 trillion of real GDP, labor productivity is $50,000 per worker. Productivity is determined by the level of technology and by physical and human capital per worker, which is why those sources of growth matter so much for living standards.

Economic growth in our models

Economic growth can be viewed as an outward shift of either the $PPC$ or $LRAS$.

Thus when we think about the $AD$-$AS$ model, it is perhaps most appropriate to view a single graph as a snapshot of a given year.

Growth enhancing policies

Governments around the world make efforts to directly or indirectly cause economic growth. The standard fiscal policy tools of government spending and taxation are demand-side policy. This is primarily used for stabilization rather than encouragement of growth.

When this does encourage growth is when direct spending, transfer payments, taxes or regulations encourage more

• Education/training
• Research and development
• Construction of infrastructure

Education and training and lead to higher levels of human capital. Research and development is more about utilizing human capital to develop new ideas and technology, as well as making existing ideas and technology more efficient. Both of these often lead to higher productivity.

Infrastructure refers to capital investments that enable economic activity. Things such as roads, highways, communications networks, and power and water delivery systems. These are often public goods, requiring significant investment from government to be provided in large enough amounts.

Supply side policies

Government policies that focus on incentivizing business behavior, are referred to as supply side policies. These include taxes, subsidies and regulations.

One example is tax cuts or subsidies to encourage specific activities, such as investment or moving manufacturing from a foreign location to a domestic location. Also falling under this term is deregulation, the loosening or removal of previously established rules on business activity.

If such policies are applied to a large portion of the economy, then these can be thought of as shifters for the $LRAS$ curve. Board changes in the corporate tax rate certainly qualify, but subsidies focused on one or two industries would likely not.

Summary of impacts to $LRAS$

Here ishow we would expect the major factors discussed in this subchapter to impact the $LRAS$ curve.