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Economic growth

Economic growth is the increase in the value of goods and services produced by an economy. It is conventionally measured as the percent rate of increase in real gross domestic product, or GDP. Growth is usually calculated in real terms, i.e. inflation-adjusted terms, in order to net out the effect of inflation on the price of the goods and services produced. In economics, "economic growth" or "economic growth theory" typically refers to growth of potential output, i.e., production at "full employment," rather than growth of aggregate demand.


Origins of the concept of Economic Growth

In the early modern period, some people in Western European nations began conceiving of the idea that economies could "grow", that is, produce a greater economic surplus which could be expended on something other than religious or governmental projects (such as war). The previous view was that only increasing either population or tax rates could generate more surplus money for the Crown or country.

During much of the "Mercantilist" period, growth was seen as involving an increase in the total amount of specie, that is circulating medium such as silver and gold, under the control of the state. This "Bullionist" theory led to policies to force trade through a particular state, the acquisition of colonies to supply cheaper raw materials which could then be manufactured and sold.

Later, such trade policies were justified instead simply in terms of promoting domestic trade and industry. The post-Bullionist insight that it was the increasing capability of manufacturing which led to policies in the 1700's to encourage manufacturing in itself, and the formula of importing raw materials and exporting finished goods. Under this system high tariffs were erected to allow manufacturers to establish "factories". (The word comes from "factor", the term for someone who carried goods from one stage of production to the next.) Local markets would then pay the fixed costs of capital growth, and then allow them to export abroad, undercutting the prices of manufactured goods elsewhere. Once competition from abroad was removed, prices could then be increased to recoup the costs of establishing the business.

Under this theory of growth, the road to increased national wealth was to grant monopolies, which would give an incentive for an individual to exploit a market or resource, confident that he would make all of the profits when all other extra-national competitors were driven out of business. The "Dutch East India company" and the "British East India company" were examples of such state-granted trade monopolies.

It should be stressed that Mercantilism was not simply a matter of restricting trade. Within a country, it often meant breaking down trade barriers, building new roads, and abolishing local toll booths, all of which expanded markets. This corresponded to the centralization of power in the hands of the Crown (or "Absolutism"). This process helped produce the modern nation-state in Western Europe.

Internationally, Mercantilism led to a contradiction: growth was gained through trade, but to trade with other nations on equal terms was disadvantageous. This – along with the rise of nation-states –encouraged several major wars.

The modern conception of economic growth began with the critique of Mercantilism, especially by the physiocrats and with the Scottish Enlightenment thinkers such as David Hume and Adam Smith, and the foundation of the discipline of modern political economy. The theory of the physiocrats was that productive capacity, itself, allowed for growth, and the improving and increasing capital to allow that capacity was "the wealth of nations". Whereas they stressed the importance of agriculture and saw urban industry as "sterile", Smith extended the notion that manufacturing was central to entire economy.

David Ricardo would then argue that trade was a benefit to a country, because if one could buy a good more cheaply from abroad, it meant that there was more profitable work to be done here. This theory of "comparative advantage" would be the central basis for arguments in favor of free trade as an essential component of growth.

This notion of growth as increased stocks of capital goods (means of production) was codified as the Solow-Swann Growth Model, which involved a series of equations which showed the relationship between labor-time, capital goods, output, and investment. In this modern view, the role of technological change became crucial, even more important than the accumulation of capital.

The late 20th century, with its global economy of a few very wealthy nations, and many very poor nations, led to the study of how the transition from subsistence and resource-based economies, to production and consumption based ecomomies occurred, leading to the field of Development economics, including the work of Amartya Sen and Joseph Stiglitz.

The Question of Growth

The real GDP per capita of an economy is often used as an indicator of the average standard of living of individuals in that country, and economic growth is therefore often seen as indicating an increase in the average standard of living.

However, there are some problems in using growth in GDP per capita to measure increasing well-being. These include:

  • expenditure to offset the adverse environmental effects of economic growth such as pollution. (These are called defensive expenditure.)
  • economic 'bads' such as commuting costs.
  • measurement of non-marketed output such as housework. (If an individual hires a cleaner instead of cleaning their house themselves, it adds to GDP, but welfare may not have risen. The time spent cleaning the house before was not counted as part of GDP, while it is counted now. The house may or may not be cleaner.)
  • some good output may not be included in GDP e.g. parents doing childcare, do-it-yourself, and volunteer work.
  • inequality (the uneven distribution of income). (If we assume diminishing marginal utility of income, extra income yields less utility for those with already-high incomes than for those with low incomes, so an increase in GDP may increase utility by different amounts depending upon individual's place in distribution. In particular, economic growth which yields savings not passed down to customers may disproportionately benefit stockholders, who are likely already wealthy)

Other measures of national income, such as the Index of Sustainable Economic Welfare or the Genuine Progress Indicator, have been developed in an attempt to give a more complete picture of the level of well-being, but there is no consensus as to which, if any, is a better measure than GDP. GDP still remains by far the most often-used measure, especially since, all else equal, a rise in real GDP is correlated with an increase in the availability of jobs, which are necessary to most individuals' survival.

The short-run variation of economic growth is termed the business cycle, and almost all economies experience periodical recessions. The cycle can be a misnomer as the fluctuations are not always regular. Explaining these fluctuations is one of the main focuses of macroeconomics. There are different schools of thought as to the causes of recessions but some consensus- see Keynesianism, Monetarism, New classical economics and New Keynesian economics. Oil shocks, war and harvest failure are obvious causes of recession. Short-run variation in growth has generally dampened in higher income countries since the early 90s and this has been attributed, in part, to better macroeconomic management.

The long-run path of economic growth is one of the central questions of economics; despite the caveats given above, an increase in GDP of a country is generally taken as an increase in the standard of living of its inhabitants. Over long periods of time, even small rates of annual growth can have large effects through compounding. A growth rate of 2.5% per annum will lead to a doubling of GDP within 30 years, whilst a growth rate of 8% per annum (experienced by some East Asian Tigers) will lead to a doubling of GDP within 10 years.

The neo-classical growth model, developed by Robert Solow in the 1950s, was the first attempt to model long-run growth analytically. This model assumes that countries use their resources efficiently and that there are diminishing returns to capital and labor increases. From these two premises, the neo-classical model makes three important predictions. First, increasing capital relative to labor creates economic growth, since people can be more productive given more capital. Second, poor countries with less capital per person will grow faster because each investment in capital will produce a higher return than rich countries with ample capital. Third, because of diminishing returns to capital, economies will eventually reach a point at which no new increase in capital will create economic growth. This point is called a "steady state." The model also notes that countries can overcome this steady state and continue growing by inventing new technology that allows production with fewer resources, but the model assumes technological progress, "exogenizing" technology from the model.

Unsatisfied with Solow's explanation, economists worked to "endogenize" technology in the 1980s. They developed the endogenous growth theory that includes a mathematical explanation of technological advancement. This model also incorporated a new concept of human capital, the skills and knowledge that make workers productive. Unlike physical capital, human capital has increasing rates of return. Therefore, overall there are constant returns to capital, and economies never reach a steady state. Growth does not slow as capital accumulates, but the rate of growth depends on the types of capital a country invests in. Research done in this area has focussed on what increases human capital (e.g. education) or technological change (e.g. innovation).

Analysis of recent economic success shows a close correlation between growth and climate, though the actual linkage between the two--and possible causal mechanisms--remains a topic of hot debate. Cold states like Sweden are much more successful economically than warm countries like Nigeria. In early human history, economic as well as cultural development was concentrated in warmer parts of the word, like Egypt. Today, however, cold, Northern states have much higher GDP per capita compared to the hot, tropical states. This aspect of economics (economic geography)--and its influence on human migration and political structures--was extensively studied by Ellsworth Huntington, a professor of Economics at Yale University in the early 20th century.

The limits to growth

The limits to growth debate considers the ecological impact of growth and wealth creation. Many of the activities required for economic growth use non-renewable resources. Many researchers feel these sustained environmental effects can have an effect on the whole ecosystem. They claim the accumulated effects on the ecosystem put a theoretical limit on growth. Some draw on archaeology to cite examples of cultures they claim have disappeared because they grew beyond the ability of their ecosystems to support them. The claim is that the limits to growth will eventually make growth in resource consumption impossible.

Others are more optimistic and believe that, although localized environmental effects may occur, large scale ecological effects are minor. The optimists claim that if these global-scale ecological effects exist, human ingenuity will find ways of adapting to them.

The rate or type of economic growth may have important consequences for the environment (the climate and natural capital of ecologies). Concerns about possible negative effects of growth on the environment and society led some to advocate lower levels of growth, from which comes the idea of uneconomic growth, and Green parties which argue that economies are part of a global society and a global ecology and cannot outstrip their natural growth without damaging them.

Canadian scientist David Suzuki stated in the 1990s that ecologies can only sustain typically about 1.5-3% new growth per year, and thus any requirement for greater returns from agriculture or forestry will necessarily cannibalize the natural capital of soil or forest. Some think this argument can be applied even to more developed economies. Mainstream economists would argue that economies are driven by new technology — for instance, we have faster computers today than a year ago, but not necessarily physically more computers. We may have been able to break free from physical limitations by relying on more knowledge rather than more physical production.

A concern for promoting economic growth over and above all less measurable considerations is a symptom of productivism--usually a pejorative term.

See also

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Last updated: 10-12-2005 23:14:03
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