How Does Economic Growth Work?
Economic growth is the increase in the value of an economy's goods and services, which creates more profit for businesses. As a result, stock prices rise. That gives companies capital to invest and hire more employees.
As more jobs are created, incomes rise. Consumers have more money to buy additional products and services, and purchases drive higher growth. For this reason, all countries want positive economic growth. This makes economic growth the most-watched economic indicator.
Example of Economic Growth
As an example, take a look at the U.S. economy in the 1980s. After two economic contractions in the first three years of the decade, the economy began to boom. Almost 19 million jobs were added over the decade, although unevenly. Sectors such as manufacturing and mining lost jobs, but others, such as service and retail, expanded rapidly. More women entered the workforce during the 1980s, too. This soaring productivity plus a weakening dollar abroad helped U.S. companies meet the increased demand for exports and revenue rose accordingly.
By the decade's end, gross domestic product (GDP) had skyrocketed from $2.8 trillion in 1980 to $5.5 trillion by 1989.
How To Measure Economic Growth
Gross domestic product is the best way to measure economic growth because it takes into account the country's entire economic output. GDP includes all goods and services that businesses in the country produce for sale. It doesn't matter whether they are sold domestically or overseas.
GDP measures final production. It doesn't include the parts that are manufactured to make a product. GDP includes exports because they are produced in the country. Imports are subtracted from economic growth.
Most countries measure economic growth each quarter.
The most accurate measurement of growth is real GDP, which removes the effects of inflation. The GDP growth rate uses real GDP.
The World Bank uses gross national income instead of GDP to measure growth. It includes income sent back by citizens who are working overseas. That is a critical source of income for many emerging market countries such as Mexico. Comparisons of GDP by country will understate the size of these countries' economies.
|Top 10 Countries by GDP|
|Country||GDP (in millions)|
What GDP Does (and Does Not) Include
GDP is not the only measure of economic growth. For starters, it doesn't include unpaid work, such as dependent care or volunteer work. It also doesn't include illegal, black-market activities.
Gross domestic product also does not account for environmental costs. For example, the price of plastic seems cheap because it doesn't include the cost of disposal. As a result, GDP doesn't measure how these costs affect the well-being of society at large.
A country will improve its standard of living when it factors in environmental costs.
Similarly, societies only measure what they value—and they only value what they measure. For example, Nordic countries rank high in the World Economic Forum's Global Competitiveness Report. Their budgets focus on the drivers of economic growth, which are world-class education, social programs, and a high standard of living. These factors create a skilled and motivated workforce.
These countries have a high tax rate. But they use the revenues to invest in the long-term building blocks of economic growth.
This economic policy contrasts with that of the United States. The U.S. uses debt to finance short-term growth through boosting consumer and military spending. That's because these activities do show up in GDP, which the U.S. uses to measure its economic growth.
Riane Eisler's book, “The Real Wealth of Nations,” proposes changes to the U.S. economic system by giving value to activities at the individual, societal, and environmental levels.
The Phases of Economic Growth
Analysts watch economic growth to discover what stage of the business cycle the economy is in. The best phase is expansion. This is when the economy is growing in a sustainable fashion. If growth is too far beyond a healthy growth rate, it overheats. That creates an asset bubble, which is what happened to the housing sector in 2005-2006. As too much money chases too few goods and services, inflation kicks in. This is the "peak" phase in the business cycle.
At some point, confidence in economic growth dissipates. When more people sell than buy, the economy contracts. When that phase of the business cycle continues, it becomes a recession. An economic depression is a recession that lasts for a decade. The only time this happened was during the Great Depression of 1929.
The chart below shows the different phases of the U.S. economy.
Inflation in the U.S. topped 9% in June 2022, stoking fears of a recession.
Causes of U.S. Growth
The United States has an abundance of the four factors of production. These are land/natural resources, labor, capital equipment, and entrepreneurship.
Land and natural resources: The United States’ large landmass compares to those of Russia, Canada, and Australia. But it has more natural resources than these countries. The best of these are:
- Tillable soil in the Great Plains often called the breadbasket of the world
- A temperate climate
- Freshwater lakes and rivers
- Large deposits of oil, coal, and natural gas
Canada and Russia are thwarted by a cold climate. Australia is dry.
Labor: The U.S. labor force is large, skilled, and mobile. It responds quickly to changing business needs. The large and diverse population provides a home-grown test market. It gives domestic companies experience in knowing what consumers want. This has given the United States a comparative advantage in producing consumer products. As a result, almost 70% of what the country produces is for personal consumption.
Capital equipment: U.S. companies have an advantage in exporting, and as a result, the United States is the world's second-largest exporter. This has allowed the country to excel in producing the fourth factor of production, capital equipment. These include computers, semiconductors, and medical equipment. It also includes industrial machinery and equipment.
Entrepreneurship: The U.S. services industry is also innovative. The most successful industries are financial services, health care, and intellectual property such as computer software.
Ways to Spur Economic Growth
If a country is not blessed with the factors of production, it must find other ways to spur growth. Governments want to increase growth because it increases tax revenue. Growth allows businesses to hire workers, increasing their income. When people feel prosperous, they reward political leaders by re-electing them.
The government stimulates growth with expansive fiscal policy. It either spends more, cuts taxes, or both. Since politicians want to get re-elected, they use expansive fiscal policy to stimulate the economy.
But expansive fiscal policy is addictive. If the government keeps spending more and taxing less, it leads to deficit spending. It works for a while but eventually leads to higher debt levels. In time, as the debt-to-GDP ratio approaches 100%, it slows economic growth. Foreign investors stop investing funds in a country with a high debt ratio. They worry they won't get repaid or that the money will be worth less.
Governments should then be careful with expansive fiscal policy and should only use it when the economy is in contraction or recession. When the economy is growing, its leaders should cut back on spending and raise taxes. This conservative fiscal policy ensures that economic growth will remain sustainable.
A nation's central bank can also spur growth with monetary policy. It can increase the money supply by lowering interest rates. Banks make borrowing for cars, college, and homes less expensive. They also reduce credit card interest rates. All of these boost consumer spending and economic growth.
- Economic growth is the increase in the value of an economy's goods and services over time.
- Real gross domestic product is the best way to measure economic growth, because it removes the effects of inflation.
- The government stimulates growth with expansive fiscal policy by spending more or cutting taxes.
- Over time, expansive fiscal policy can lead to deficit spending, higher debt levels, and slowing economic growth.
Frequently Asked Questions (FAQs)
Why is economic growth important?
Economic growth increases a nation's prosperity. Prosperous nations are better able to care for their citizens and raise their standard of living.
Which factors contribute to economic growth?
The four factors that drive economic growth are natural resources, labor, capital equipment, and entrepreneurship. The U.S. has all four in abundance.
Which policies contribute to economic growth?
Expansive fiscal policy and monetary policy are both ways to spur economic growth. With an expansive fiscal policy, the government spends more, taxes less, or both. Monetary policy is set by a nation's central bank. In the U.S., the Federal Reserve sets monetary policy to try to maintain sustainable growth, using tactics such as raising or lowering interest rates to influence economic growth.
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U.S. Bureau of Economic Analysis. "Table 1.—Gross Domestic Product—Continued."
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Jane Dokko, Brian Doyle, Michael T. Kiley, Jinill Kim, Shane Sherlund, Jae Sim, and Skander Van den Heuvel. "Monetary Policy and the Housing Bubble," Finance and Economics Discussion Series (FEDS).
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