What economic growth means
In the short run, real GDP rises and falls with the business cycle (Topic 2.7). Over many years, though, most economies produce more and more. Economic growth in this topic means that long-run rise in the economy’s capacity to produce: its full-employment level of output gets bigger.
Growth matters because it is the main way the average standard of living rises. To measure that, economists look at output per person.
Measuring growth: real GDP per capita
Two adjustments turn GDP into a measure of living standards.
- Use real GDP, not nominal GDP. Nominal GDP can rise just because prices rise. Real GDP removes the effect of inflation (Topic 2.6): real GDP = nominal GDP ÷ GDP deflator × 100.
- Divide by the population. Real GDP per capita = real GDP ÷ population. This is the average output per person.
Economic growth is measured as the growth rate of real GDP per capita:
Growth rate = (real GDP per capita this year − real GDP per capita last year) ÷ real GDP per capita last year × 100
A useful shortcut. Growth in real GDP per capita ≈ growth in real GDP − growth in population. The shortcut is close when rates are small; for an exact answer, calculate per capita values first.
Worked example 1: is the average Valdorian better off?
Valdoria is the fictional country used across the Marlbridge macroeconomics pages; its currency is the valda (VD). All data are fictional.
| Year 1 | Year 2 | |
|---|---|---|
| Nominal GDP (VD billion) | 840 | 970.2 |
| GDP deflator (Year 1 = 100) | 100 | 110 |
| Population (million) | 40.0 | 41.2 |
Question. (a) Calculate real GDP in each year. (b) Calculate real GDP per capita in each year. (c) Calculate the rate of economic growth. (d) A newspaper reports that “the economy grew 15.5%”. Explain why this overstates growth in living standards.
(a) Year 1 is the base year, so real GDP = VD 840 billion. Year 2: 970.2 ÷ 110 × 100 = VD 882 billion. Real GDP grew (882 − 840) ÷ 840 × 100 = 5%.
(b) Year 1: 840 billion ÷ 40.0 million = VD 21,000 per person. Year 2: 882 billion ÷ 41.2 million = VD 21,407.77 per person.
(c) (21,407.77 − 21,000) ÷ 21,000 × 100 = 1.94%.
Check with the shortcut. Population grew (41.2 − 40.0) ÷ 40.0 × 100 = 3%. Real GDP growth − population growth = 5% − 3% = 2%, close to the exact 1.94%.
(d) 15.5% is the growth of nominal GDP: (970.2 − 840) ÷ 840 × 100. Most of it is a higher price level (10%), and part of the real growth is shared among 3% more people. The average Valdorian’s real output rose by under 2%.
What if? If real GDP had grown only 2% (to VD 856.8 billion) with the same population, real GDP per capita would be 856.8 billion ÷ 41.2 million = VD 20,796.12, a fall of 0.97%. Total output can rise while living standards fall.
The aggregate production function
What determines how much an economy can produce? The aggregate production function links the economy’s total output to its inputs:
- the quantity of labour (the number of people employed),
- physical capital: machines, buildings, tools and infrastructure,
- human capital: the skills, knowledge, education and health of workers,
- technology: the know-how that turns inputs into output.
Employment and output are directly related. Holding capital and technology constant, firms must employ more workers to produce more output, and more workers produce more output. So total real GDP rises with employment. But more workers on their own do not necessarily raise output per person; for that you need each worker to produce more.
Labour productivity
Labour productivity is output per employed worker:
Labour productivity = real GDP ÷ number of employed workers
Productivity is determined by three things, each measured per worker:
| Determinant | What it means | Example |
|---|---|---|
| Physical capital per worker | More or better equipment for each worker | A farm worker with a tractor instead of a hoe |
| Human capital per worker | More education, training, skills and better health | Nurses completing an extra year of training |
| Technology | Better methods and ideas for combining inputs | A new crop variety that yields more grain per hectare |
The aggregate production function shows that output per capita rises with physical capital per capita and with human capital per capita. Better technology raises the output you get from any given amount of capital.
Background, not required. Many textbooks draw the curve getting flatter, as in Figure 1: each extra unit of capital per worker adds a little less output than the one before (diminishing returns). That is why sustained growth in living standards depends heavily on improving technology and human capital, not only on piling up machines.
Worked example 2: where did Kestria’s growth come from?
Kestria is a second fictional country that also uses the valda.
| Year 1 | Year 2 | |
|---|---|---|
| Real GDP (VD billion) | 160 | 176.4 |
| Employed workers (million) | 4.0 | 4.2 |
| Population (million) | 6.0 | 6.12 |
Question. (a) Calculate labour productivity in each year and its growth rate. (b) Calculate the growth rates of real GDP and of real GDP per capita. (c) Identify the two sources of Kestria’s growth in real GDP, and explain which one is more likely to keep raising living standards in the long run.
(a) Year 1: 160 billion ÷ 4.0 million = VD 40,000 per worker. Year 2: 176.4 billion ÷ 4.2 million = VD 42,000 per worker. Growth: (42,000 − 40,000) ÷ 40,000 × 100 = 5%.
(b) Real GDP: (176.4 − 160) ÷ 160 × 100 = 10.25%. Real GDP per capita: 160 billion ÷ 6.0 million = VD 26,666.67; 176.4 billion ÷ 6.12 million = VD 28,823.53. Growth = 8.09%.
(c) Real GDP = employment × productivity. Employment rose 5% and productivity rose 5%, and 1.05 × 1.05 = 1.1025, which is the 10.25% rise in real GDP.
- More employment. Employment grew faster than the population (5% against 2%), so a larger share of people worked (66.67% to 68.63%). This raised output per capita, but it cannot go on for ever: the share of people working has a ceiling.
- Higher productivity. Each worker produced 5% more, from more physical or human capital per worker or better technology. This can keep rising year after year.
So productivity growth is the more lasting source of rising living standards. As a check: if productivity had stayed at VD 40,000, real GDP would have been 4.2 million × 40,000 = VD 168 billion, and real GDP per capita would have risen only 2.94%.
Showing growth on graphs: the PPC and LRAS
Growth is an increase in the economy’s capacity, so it shows up in both capacity models you have met.
- On a production possibilities curve (PPC), growth is an outward shift of the curve.
- In the AD–AS model, growth is a rightward shift of the LRAS curve, from Yf₁ to a higher Yf₂.
The two shifts are the same event drawn in two ways. Both show that full-employment output has increased. Anything that raises productivity or the quantity of resources, such as more physical capital, more human capital, better technology or a larger labour force, shifts both. The upward-sloping long-run trend line on a business-cycle graph (Topic 2.7) tells the same story.
Growth versus recovery. A movement from a point inside the PPC to a point on it, or a rise in real GDP from below Yf back to Yf, uses idle resources. It is a recovery, not long-run growth, because capacity has not changed. The PPC and LRAS do not move.
Today’s choices, tomorrow’s capacity. An economy that produces more capital goods today (a point higher up its PPC) builds more physical capital per worker, so its PPC and LRAS tend to shift out further in future. This is why crowding out of private investment (Topic 5.5) can slow growth.
Common misconceptions
- “Nominal GDP growth is economic growth.” Remove inflation first; then divide by the population.
- “Real GDP growth equals growth in living standards.” Not if the population is also growing. Use real GDP per capita.
- “Labour productivity is output per person in the country.” It is output per employed worker. Output per person is real GDP per capita.
- “More workers always raise living standards.” More employment raises total output, but output per worker rises only with more capital per worker, more human capital or better technology.
- “A rightward shift of AD is economic growth.” AD shifts change output in the short run. Long-run growth is a shift of LRAS (and the PPC).
- “A higher price level shifts LRAS right.” The price level does not change capacity.
- “Moving from inside the PPC to the curve is growth.” That is a recovery that uses idle resources; capacity is unchanged.
- “A larger population with the same capital raises productivity.” Physical capital per worker falls, so productivity tends to fall, not rise.
Where this leads
In Topic 5.7 you will look at what governments can do to raise long-run growth, such as investing in infrastructure, education and research, and supply-side fiscal policies: continue with the public policy and economic growth study guide. For the link between borrowing and capital, go back to Topic 5.5; for LRAS, see Topic 3.4.
Now try the practice questions, then use the revision notes and the checklist to consolidate.
Quick questions
Why per capita and not just real GDP?
Real GDP can rise simply because there are more people. Dividing by the population shows whether the average person has more goods and services, which is what growth in living standards means.
Is a recovery from a recession economic growth?
Not in the long-run sense used here. A recovery moves output back towards full employment, from a point inside the PPC towards the curve. Long-run growth means full-employment output itself rises, so the PPC and LRAS shift.