Measuring economic growth

Economic growth refers to an increase in the production of goods and services in an economy over time. It reflects an economy's ability to produce more, which can lead to higher living standards. Economists measure this growth in ways that account for population changes and inflation to get a clear picture.

Key measures of economic growth

• Real GDP (gross domestic product) - The total value of all final goods and services produced in an economy, adjusted for inflation to show actual changes in output.
• Real GDP per capita - Real GDP divided by the population, which shows average output per person and accounts for population growth.
• Economic growth rate - The percentage change in real GDP per capita over time, providing a standardized way to compare growth across periods or countries.

Economic growth is typically calculated as the growth rate in real GDP per capita. This measure helps determine if an economy is expanding in a way that benefits individuals, as it adjusts for both inflation and population size.

Formula for economic growth rate

$\text{Economic growth rate}=\frac{\text{new real GDP per capita}-\text{old real GDP per capita}}{\text{old real GDP per capita}}\times 100$

Where:

• New real GDP per capita = Real GDP per capita in the current period
• Old real GDP per capita = Real GDP per capita in the previous period

This formula expresses growth as a percentage, making it easier to analyze trends.

Determinants of economic growth

Several factors drive economic growth by increasing an economy's capacity to produce more goods and services. These determinants focus on improving efficiency and resources available per worker. As a result, economies can expand without relying solely on adding more labor.

Main determinants

• Productivity - The amount of output produced per unit of input, often measured as output per employed worker (average labor productivity). Higher productivity means more goods and services from the same resources.
• Physical capital - Tangible assets like machinery, buildings, and tools that workers use to produce goods. More physical capital per worker boosts output.
• Human capital - The skills, knowledge, and education of the workforce. Investments in training and education increase human capital, leading to better productivity.
• Technology - Advances in methods, processes, or inventions that allow more efficient production. Technology enhances both physical and human capital.

These determinants are interconnected. For example, better technology can make physical capital more effective, while improved human capital helps workers use technology efficiently.

How determinants affect growth

An increase in any determinant shifts the production possibilities curve (PPC) outward, representing higher potential output. This occurs because the economy can produce more with the same resources. Data from economies often shows that countries with high investments in human capital and technology experience faster growth rates in real GDP per capita.

The aggregate production function

The aggregate production function is a model that shows how an economy's total output relates to its inputs, such as labor, capital, and technology. It helps explain why some economies grow faster than others by linking inputs to output levels.

This function assumes that aggregate employment (total number of workers) and aggregate output (total production) are directly related. Firms hire more workers to increase output, holding other factors constant.

Formula for the aggregate production function

$Y=f(L,K,H,T)$

Where:

• Y = Total output (real GDP)
• L = Labor (number of workers)
• K = Physical capital
• H = Human capital
• T = Technology
• f = The function showing how these inputs combine to produce output

Key relationships in the aggregate production function

• Output per capita - Total output divided by population, which rises with increases in physical and human capital per capita.
• Positive relationships - More physical capital per worker or better human capital leads to higher output per capita, as workers become more efficient.

For instance, if human capital improves through education, the function predicts higher Y for the same L, demonstrating growth.

Relationship between the production possibilities curve and long-run aggregate supply

The production possibilities curve (PPC) is a graph showing the maximum combinations of two goods an economy can produce with full employment of resources. It illustrates trade-offs and efficiency. The long-run aggregate supply (LRAS) curve represents the economy's potential output when all resources are fully employed, unaffected by price levels in the long run.

These models are connected because both depict an economy's full employment output level.

How PPC relates to LRAS

• An outward shift in the PPC means the economy can produce more of both goods, which corresponds to a rightward shift in the LRAS curve.
• This shift happens due to improvements in determinants like technology or capital, increasing potential output.
• The PPC's frontier represents full employment, similar to the vertical LRAS curve at the full-employment output level.

For example, if new technology allows more efficient production, the PPC bows outward, and the LRAS shifts right, showing higher sustainable output without inflation.

Worked example - Calculating per capita GDP and economic growth rate

A country has a real GDP of $1,200 billion in Year 1 with a population of 300 million. In Year 2, real GDP rises to $1,260 billion, and the population grows to 305 million. Calculate the real GDP per capita for both years and the economic growth rate.

Step 1: Identify the values

• Year 1 real GDP = $1,200 billion
• Year 1 population = 300 million
• Year 2 real GDP = $1,260 billion
• Year 2 population = 305 million

Step 2: Calculate real GDP per capita for each year

$\text{Real GDP per capita (Year 1)}=\frac{\$\mathrm{1,200}\text{ billion}}{300\text{ million}}=\$\mathrm{4,000}$

$\text{Real GDP per capita (Year 2)}=\frac{\$\mathrm{1,260}\text{ billion}}{305\text{ million}}=\$\mathrm{4,131}$

Step 3: Calculate the economic growth rate

$\text{Economic growth rate}=\frac{\$\mathrm{4,131}-\$\mathrm{4,000}}{\$\mathrm{4,000}}\times 100=3.28\%$

Step 4: Interpretation

The economy grew by 3.28% in real GDP per capita terms, indicating improved average output per person after accounting for population growth.