Sources of Economic Growth - Overview

Author: Geoff Riley  Last updated: Sunday 23 September, 2012

Introduction

What is economic growth?

Economic growth is a long-term expansion of the productive potential of the economy.

Trend growth refers to the smooth path of long run national output

Measuring the trend rate of growth requires a long-run series of data perhaps of 20 years or more in order to calculate average growth rates from peak to peak. 

The table below tracks the growth rates achieved in the world economy for three recent years and also for developing countries excluding China and India.

What determines the rate of economic growth?

• There have been numerous research studies in what determines long term GDP growth
• Every country is different, each factor will vary in importance for a country at a given point in time
• Remember too that in our inter-connected globalising world, growth does not happen in isolation. Events in one country and region can have a significant effect on growth prospects in another

Growth Drivers

Here are some of the main determinants of economic growth – they apply for both developing and developed countries although the relative weighting that we might attach to each will depend on the individual circumstances facing each country or region.

Growth is not the same as development! Growth can support development but the two are distinct – an important point to make in any A2 macro essay or data response question.

Threats / Challenges to Growth

Many factors can throw a country off their projected long run economic growth path – some of these will be negative for growth, others will be positive. Many of the world’s least developed countries are highly vulnerable and this makes their growth paths and projections uncertain and fragile.

Rising AD and Growing LRAS – Key Drivers of Economic Growth

Increases in long run aggregate supply bring about a rise in productive potential. Higher levels of aggregate demand for goods and services provide the impetus for this productive potential to be used.

The Harrod-Domar Growth Model

The Harrod Domar Growth model is a model and not a growth strategy! A model helps to explain how growth has occurred and how it may occur again in the future. Growth strategies are the things a government might introduce to replicate the outcome suggested by the model. The Harrod-Domar growth model stresses the importance of savings and investment as key determinants of growth. Basically, the model suggests that the economy’s rate of growth depends on:

• The level of national saving (S)
• The productivity of capital investment (this is known as the capital-output ratio)

The Capital-Output ratio (COR)

• For example, if £100 worth of capital equipment produces each £10 of annual output, a capital-output ratio of 10 to 1 exists. A 3 to 1 capital-output ratio indicates that only £30 of capital is required to produce each £10 of output annually.
• If the capital-output ratio is low, an economy can produce a lot of output from a little capital. If the capital-output ratio is high then it needs a lot of capital for production, and it will not get as much value of output for the same amount of capital.

Key point: When the quality capital resources is high, then the capital output ratio will be lower

Rate of growth of GDP = Savings ratio / capital output ratio

Numerical examples:

• If the savings rate in the economy is 10% and the capital output ratio is 2, then the country would grow at 5% per year.
• If the savings rate in the economy is 20% and the capital output ratio is 1.5, then the country would grow at 13.3% per year.
• If the savings rate in the economy is 8% and the capital output ratio is 4, then the country would grow at 2% per year.

Based on the model therefore the rate of growth in an economy can be increased in one of two ways:

• Increased level of savings in the economy (national savings)
• Reducing the capital output ratio (i.e. increasing the quality of capital inputs)

LDCs often have an abundant supply of labour it is a lack of physical capital that holds back economic growth and development. Boosting investment generates economic growth which leads to a higher level of national income. Higher incomes allow more people to save.

Limitations / problems of the Harrod-Domar Model

• Increasing the savings ratio in lower-income countries is not easy. The majority of developing countries have low marginal propensities to save. Extra income gained is often spent on increased consumption rather than saved. Many countries suffer from a persistent domestic savings gap.
• Many developing countries lack a sound financial system. Increased saving by households does not necessarily mean there will be greater funds available for firms to borrow to invest.
• Efficiency gains that reduce the capital/output ratio are difficult to achieve in developing countries due to weaknesses in human capital, causing capital to be used inefficiently
• Research and development (R&D) is needed to improve the capital/output ratio is often underfunded
• Borrowing from overseas to fill a gap caused by insufficient savings causes external debt repayment problems later.
• The accumulation of capital will increase if the economy starts growing dynamically – a rise in capital spending is not necessarily a pre-condition for economic growth and development – as a country gets richer, incomes rise, so too does saving, and the higher income fuels rising demand which itself prompts a rise in capital investment spending.

Capital Investment and Growth in China

China is often cited as a country where a rising share of capital investment as a % of GDP has been a major driver of fast economic growth over the last twenty years. Evidence for this is provided in the chart above and it shows that capital spending as a % of GDP grew from less than 30% in the 1970s to over 40% in the mid 1990s – rising further still since 2000. In most developed countries it is now around 20% or less.

A rise in capital spending will have important effects on both the demand and supply-side – including a positive multiplier effect on national income.

• Demand side effects: Increase spending on capital goods boosts demand for industries that manufacture the technology / hardware / construction sector
• Supply side effects: Investment is linked to higher productivity, an expansion of a country’s productive capacity, a reduction in unit costs (e.g. through the exploitation of economies of scale) – and therefore a source of an increase in potential national output
• One way to remember the importance of investment is to consider the 3 Cs - capacity, costs and competitiveness. Higher investment should allow businesses to lower their production costs per unit, increase their supply capacity and become more competitive in overseas markets.

Limits to investment-driven economic growth

• Although investment is important – not least capital spending to boost a country’s infrastructure, it is important to consider too the quality of investment.
• A high level of investment on its own may not be sufficient to create an increase in LRAS  since workers need training to work the new machinery and there will be time lags between new capital spending and the effects on output and productivity.
• Also, if there is insufficient consumer demand for goods and services, a growing capital stock may lead to excess capacity putting downward pressure on prices and profits
• Investment might be unbalanced – for example too much capital going to speculative real estate (property) projects rather than investment in new businesses
• There might be a risk of diminishing returns to extra investment – i.e. a given increase in capital spending leads to a smaller rise in a nation’s GDP
• When growth is capital intensive, higher profits flow to owners of this capital and to businesses than produce the investment goods. The result can be an increase in income and wealth inequality as other sectors of the economy do not see the same benefits from economic growth.

Neo-Classical Growth – The Solow Model

The economist Robert Solow (pictured) developed the neo-classical theory of economic growth. Solow won the Nobel Prize in Economics in 1987.

Growth comes from adding more capital and labour inputs and also from ideas and new technology.

The Solow model believes that a sustained rise in capital investment increases the growth rate only temporarily: because the ratio of capital to labour goes up. However, the marginal product of additional units of capital may decline (there are diminishing returns) and thus an economy moves back to a long-term growth path, with real GDP growing at the same rate as the growth of the workforce plus a factor to reflect improving productivity. 

A ‘steady-state growth path’ is reached when output, capital and labour are all growing at the same rate, so output per worker and capital per worker are constant.

Neo-classical economists believe that to raise the trend rate of growth requires an increase in the labour supply and also a higher level of productivity of labour and capital.

Differences in the rate of technological change between countries are said to explain much of the variation in growth rates that we see.

The neo-classical model treats productivity improvements as an ‘exogenous’ variable – they are assumed to be independent of the amount of capital investment.

The Solow Model features the idea of catch-up growth when a poorer country is catching up with a richer country – often because a higher marginal rate of return on invested capital in faster-growing countries.

The Solow model predicts some convergence of living standards (measured by per capita incomes) but the extent of catch up in living standards is questioned – not least the existence of the middle-income trap when growing economies find it hard to sustain growth and rising per capita incomes beyond a certain level.

Endogenous Growth Theory

• Endogenous growth economists believe that improvements in productivity can be linked directly to a faster pace of innovation plus investment in human capital.
• They stress the need for government and private sector institutions to nurture innovation, and provide incentives for individuals and businesses to be inventive.
• Knowledge industries - typically they are in telecommunications, software or biotechnology - are becoming important in many developed and developing countries.

The main points of the endogenous growth theory are as follows:

• Government policies can raise a country’s growth rate if they lead to more intense competition in markets and help to stimulate product and process innovation
• There are increasing returns to scale from capital investment
• Private sector investment in research & development is a key source of technical progress
• The protection of property rights and patents is essential in providing incentives for businesses and entrepreneurs to engage in research and development
• Investment in human capital (the quality of the labour force) is a key ingredient of growth
• Government policy should encourage entrepreneurship as a means of creating new businesses and ultimately as an important source of new jobs, investment and innovation

Capital Investment as a % of GDP

Add your comments and share this study note:

Search tutor2u

Related study notes