Economic Growth

This article focuses on economic growth. It provides an analysis of the main theories of economic growth including neoclassical growth theory, new growth theory, and modern political growth theory. Economic growth trends in the U.S. economy and the global economy are discussed. The differences between economic growth and economic development are addressed.

Keywords Business Climate; Business Cycle; Competitiveness; Convergence; Developing Countries; Economic Development; Economic Growth; Extensive Economic Growth; Fiscal Policy; Global Economy; Globalization; Gross Domestic Product; Intensive Economic Growth; Modern Political Growth Theory; Monetary Policy; Neoclassical Growth Theory; New Growth Theory

Economics > Economic Growth

Overview

Economic growth, according to the World Bank, refers to the quantitative change or expansion in a country's economy. The economic growth of a nation is measured as the percentage increase in its gross domestic product during one year. Economic growth occurs in two distinct ways. Economic growth of a nation occurs when a nation grows extensively by using more physical, natural or human resources or intensively by using resources more efficiently or productively. Economic growth is generally considered to be either extensive or intensive in nature. Extensive economic growth refers to growth scenarios in which an increase in the gross domestic product is absorbed by a population increase without any increase in per capita income. Intensive economic growth refers to growth scenarios in which gross domestic product growth exceeds population growth creating a sustained rise in living standards as measured by real income per capita (Snowdon, 2006). According to the World Bank's approach to promoting and facilitating the economic growth of nations, intensive economic growth of nations requires economic development.

Economic Growth & Labor Productivity

Economic growth is a focus of study and concern for economists, governments, and private sector development organizations. Economists are concerned with forecasting and measuring economic growth. Governments and private sector development organizations focus on forecasting and promoting economic growth of regions and nations. Economic growth is generally promoted through efforts to increase labor productivity. Labor productivity growth is crucial to the strength and growth of economies. Labor productivity is promoted in four main ways (Vanhoudt & Onorante, 2001):

• Expand the physical capital of workers through the purchase of better machines, tools, and infrastructure.
• Improve the knowledge capital of the workforce through education and training.
• Foster a new economy by introducing new technologies to improve the productivity of all workers.
• Strengthen relations between public and private sectors to facilitate the working of the labor market and limit economic distortions caused by taxes and passive labor market policies.

Tracking & Measuring Economic Growth

Economic growth is generally tracked and measured by national governments and non-governmental economic research organizations. For example, in the United States, the National Bureau of Economic Research (NBER), the United States's leading nonprofit economic research organization, determines and records dates for economic growth cycles and business cycles in the United States. The National Bureau of Economic Research published its first business cycle dates in 1929. The National Bureau of Economic Research has, since its establishment in 1920, worked in its capacity as a private, nonprofit, nonpartisan research organization to promote a better general understanding of the way the economy works. National Bureau of Economic Research associates, including 600 professors of economics and business, develop new statistical measurements, estimate quantitative models of economic behavior, assess the effects of public policies on the U.S. economy, and project the effects of alternative policy proposals. The National Bureau of Economic Research established itself as the predominant research organization on the topic of U.S. business cycles and economic growth tracking through the bureau's early research on the aggregate economy, business cycles, and long-term economic growth in the United States.

The following section provides an overview of the main theories of economic growth: Neoclassical growth theory, new growth theory, and modern political growth theory. This section provides the foundation for later discussion of economic growth trends in the U.S. economy and the global economy and the relationship between economic growth and economic development.

Theories of Economic Growth

Economic growth has been a focus of study by economists since the eighteenth century when Adam Smith published the "Wealth of Nations." Scholarly interest in economic growth reached its peak in the mid-twentieth century following World War II. Following World War II, economists and national governments worked to find the factors and variables that controlled post-war economic growth (Snowdon, 2006). Economic growth is considered by economists to be a natural result of market activity. Economists have long been interested in the relationship between income inequality and economic growth. Growth theories refer to the theories that explain the factors and relationships that promote the economic growth of nations. Economic growth theories incorporate variables representing the effects of production factors, public expenditure, and income distribution. The following factors influence the effect that income distribution has on growth: Investment indivisibilities, incentives, credit market imperfections, macroeconomic imperfections, macroeconomic volatility, political economy aspects, and social effects (Alfranca, 2003). In the history of economic growth theories, there are three main waves or theories of economic growth: Neoclassical growth theory, new growth theory, and modern political growth theory.

Neoclassical Growth Theory

The neoclassical growth theory, also referred to as the exogenous growth model, focuses on productivity growth. The neoclassical growth theory, promoted by economists Robert Solow and Trevor Swan, was the predominant economic growth theory from the nineteenth to mid-twentieth centuries. Exogenous growth refers to a change or variable that comes from outside the system. Technological progress and enhancement of a nation's human capital are the main factors influencing economic growth. Technology, increased human capital, savings, and capital accumulation are believed to promote technological development, more effective means of production, and economic growth. The neoclassical growth theory prioritizes the same factors and variables as neoclassical economics. The field of neoclassical economics emphasizes the belief that the market system will ensure a fair allocation of resources and income distribution. In addition, the market is believed to regulate demand and supply, allocation of production, and the optimization of social organization. Neoclassical economics, along with the neoclassical growth model, began in the nineteenth century in response to perceived weaknesses in classical economics (Brinkman, 2001).

There are numerous criticisms of neoclassical growth theory. Criticism of the neoclassical growth theory focuses on the long-run productivity limitation created from the theory’s exclusive focus on the addition of capital to a national economy. In addition, the neoclassical model predicts that different countries will have different levels of per capita income, depending on the variable factors which determine income levels. The range of income levels between countries shows the magnitude of international differences is actually vast and variable. The neoclassical model also predicts that an economy will reach its steady state, which is then determined by savings and population growth rates. Comparisons of the growth rates of rich and poor countries suggest that the neoclassical model does not successfully predict the rate of convergence of all countries as poor economies tend to grow more rapidly than rich economies (Mankiw, 1995).

New Growth Theory

New growth theory, also referred to as the endogenous growth theory, began in the 1980s as a response to criticism of the neoclassical growth theory. Endogenous growth refers to a change or variable that comes from inside and is based on the idea that economic growth is created and sustained from within a country rather than through trade or other contact from outside the system. The new growth theory identifies the main endogenous factors leading to sustained growth of output per capita including research and design, education, and human capital (Park, 2006). There are three main criticisms of new growth theories: First, the new growth theory is criticized for lack of conceptual clarity in its underlying assumptions. Second, the new growth theory is criticized for lack of empirical relevancy. Third, the new growth theory is criticized for claiming to be a wholly new theory when it's closely tied to growth theories that came before. Economists debate the significance of this last criticism. The new growth theory claims to represent a total break from neoclassical theory but the continued focus on technology (whether exogenous or endogenous technology) and its relationship to economic growth, connects the two main growth theories in significant ways (Brinkman, 2001).

Modern Political Growth Theory

The modern political growth theory focuses on the fundamental determinants of economic growth such as the quality of governance, legal origin, ethnic diversity, democracy, trust, corruption, institutions in general, geographical constraints, natural resources, and connection between international economic integration and growth. The modern political economic growth theory asserts that poor countries, though they have the potential for economic growth, will never achieve economic growth so long as the countries lack supporting institutions.

These three theories vary in their argument about what causes economic growth and what role technology plays in the economic growth of nations. Neoclassical growth theory and new growth theory emphasize the conditions associated with growth while the modern political economy theory focuses on fundamental causes or determinants of economic growth (Snowsdon, 2006).

Elements Necessary for Sustained Economic Growth

Ultimately, sustained economic growth, as represented by enhanced productivity and growth, may require structural transformation within the nation. Economic growth, while encouraged and facilitated by factors such as a large labor supply, national infrastructure, and resource rich environment, is hindered by economic problems and cultural obstacles inherent in the business climate and troughs in the business cycle. Economic problems refer to factors that hinder the functioning and growth of an economy. Economic problems of all kinds, including structural, fiscal, and cultural, impact economic development efforts by national governments, corporations, and international development organizations. Economic development encompasses a wide range of programs and strategies aimed at promoting growth in a part or whole of an economy. Developing countries with limited economies or economies in transition are particularly sensitive to economic problems of child labor, creditworthiness, corruption, and poverty and its related conditions. Economic growth may require creative destruction of an old system of institutions, modes of production, and relationships. Limin, Chaobo & Junliang (2013) looked at China's growth between 1987 (a period of rapid inflation, budgetary instability, and relatively low per capita income levels) and 2010 and found that exports were a powerful driver of economic growth during the period, especially in the more developed eastern region. Toward the end of the period, however, exports became less important, imports increased, and foreign direct investment accelerated. China's entry to the World Trade Organization in 2001 undoubtedly affected the dynamics of growth in China, driving up labor costs on the one hand and facilitating FDI on the other. China, with rising income, an expanding infrastructure, and technological advances, was a natural draw for investors exploring new markets.

Applications

Economic Growth of the U.S. & Global Economies

Monetary & Fiscal Policy

The United States government controls economic activity and economic growth through the creation and implementation of monetary policy and fiscal policy. Monetary policy is a tool used by the federal government to control the supply and availability of money in the economy. Fiscal policy controls the expenditures by federal, state, and local governments and the taxes levied to finance government expenditures. The federal government promotes economic growth by adjusting government spending, interest rates, setting the tax rates, and monitoring the nation's money supply.

Economic Competitiveness

In addition to the active economic growth efforts of the United States, nations around the world are working to increase their competitiveness in the global economy and marketplace. Economic competitiveness of nations is measured and tracked with tools such as the Growth Competitiveness Index and the Business Competitiveness Index. As global competition increases and influences economic growth, these indexes are being eclipsed by the Global Competitiveness Index which tracks and measures both macroeconomic and microeconomic factors of a country's performance in the global marketplace. Competitiveness refers to the set of institutions, policies, and factors that determine the level of productivity. Increased productivity creates growth (Snowdon, 2006). The growth of nations varies between regions and historical eras. Economic and political changes promote or depress the growth of nations depending on variables such as national leadership, political and economic stability, natural resources, international relations, and infrastructure. The current era of the global economy, a product of economic globalization, is creating strong, though variable, national economic growth and development worldwide (Jones, 2005).

The Global Growth Economy

The global growth economy is characterized by the growth of nations, both in populations and in output and consumption per capita, interdependence of nations, and international management efforts. Indicators of global growth and interdependence include the huge increases in communication links, world output, international trade, and international investment since the 1970s. The global economy is built on global interdependence of economic flows linking the economies of the world. The global economy is characterized by economic sensitivity. National economic events in one region often have profound results for other regions and national economies. National economies exist not in isolation but in relationships and tension with other economies worldwide. The global economy includes numerous economic phenomena and financial tools shared between all countries. Examples include the price of gold, the price of oil, and the related worldwide movement of interest rates. Ultimately, national governments participate in the global economy in an effort to increase economic growth of their own nation.

Issues

The Relationship between Economic Growth & Economic Development

Foreign Aid & Economic Growth

The relationship between foreign aid and economic growth is strongly debated. Economists question the efficacy of foreign aid as a tool for economic growth and poverty alleviation. Private sector development organizations promote economic growth and development in developing countries in an effort to combat wide-spread poverty. Poverty, which encompasses a lack of basic necessities as well as a denial of basic opportunities and choices that permit human development, is a persistent, widespread, and intractable economic problem in developing regions. According to the World Bank, extreme poverty, and its related conditions such as hunger, affects more than one billion people in the world. The measure of extreme poverty is based on individual income or consumption levels of below $1 a day. Economic development efforts in developing countries are based on the argument that poverty reduction is tied to economic growth. Economic development, as it is practiced today, involves numerous public sector and private sector stakeholders, such as development agencies, national governments, corporations from industrialized countries, businesses from developing countries, community agencies, and populations in need, committed to ending poverty, and related conditions, in developing countries.

Combating Global Poverty

Combating global poverty is an economic development goal that unites international development organizations, national governments, and corporations around the world. For example, in 2000, the United Nations Millennium Summit was held to create time-bound and measurable goals for combating poverty and related conditions. The millennium development goals (MDGs) have become a blueprint of sorts for national governments, development agencies, and corporations committed to aiding the world's poorest people. The millennium development goals include the following objectives:

• Eradicate extreme poverty and hunger

• Achieve universal primary education

• Promote gender equality and empower women

• Reduce child mortality

• Improve maternal health

• Combat HIV/AIDS, malaria, and other diseases

• Ensure environmental sustainability

• Develop a global partnership for development (Millennium Deveopment Goals, 2000). While contemporary forms of economic development are focused primarily on eradicating extreme poverty and related conditions, economic development has been in existence, in some form, since the end of WWII. The modern era of aid to developing countries began in the 1940s as World War II ended. After WWII, world leaders and governing bodies put structures into place, such as the World Bank, United Nations, World Trade Organization, and International Monetary Fund, to prevent the economic depressions and instability that characterized the years following World War I. The modern trend of globalization, and resulting shifts from centralized to market economies in much of the world, has created both a need and opportunity for economic development in developing countries and regions of the world. International development organizations, national governments and corporations are coming together to focus on building frameworks for economic development as the basis for achieving sustainable economic growth.

International Governance Organizations & New Growth Theory

International governance organizations, such as the Organization for Economic Co-operation and Development and the United Nations, base their development and economic growth efforts on the principles of the new growth theory (also referred to as endogenous growth theory). International governance organizations, a product of the global economy, promote development and growth in nations through the adoption of principles, tools, technologies, and aid from outside the nation rather than from within the nation. More than $1 trillion was spent on foreign aid in developing countries in the last 50 years. The sum has not effectively eradicated extreme poverty. In fact, foreign aid alone has been shown to be ineffective in reducing poverty. The majority of countries report low per capita income even after receiving large amounts of foreign aid. Due to speculation that foreign aid alone cannot eradicate poverty, the World Bank reported that total foreign aid disbursements, in particular to Sub-Saharan Africa, the Middle East and North African countries, went down from 0.33% of donor countries' gross national product in 1990 to 0.24% of their gross national product in 1999. Alvi and Senbeta (2012) disaggregated foreign aid to determine whether types of aid produce different impacts on poverty and found that multilateral source-aid was more effective than aid from bilateral sources and that loans were ineffective, though grants had good results. Importantly, poverty reduction seemed to correlate with the development of financial systems. The relationship between foreign aid and economic growth suggests that greater amounts of foreign aid can, in some instances, inhibit economic growth. The conclusion that greater foreign aid may lead to lower economic growth will likely influence the direction and scope of foreign aid and foreign policy (Ali & Isse, 2005).

Economic Growth vs. Economic Development

Ultimately, economic growth and economic development are not the same process. When non-profit development organizations provide foreign aid alone to developing countries, the organizations are not promoting the structural changes necessary for economic development. There is a clear distinction between economic growth and development. The substantive nature of the economic growth and economic development processes vary. The economic growth process includes a complete transformation of a country's economic and social framework. The economic development process includes the upward movement of the entire social system. Social systems include non-economic factors such as education and health infrastructure, class stratification, the distribution of power, and general institutions and cultural attitudes. In addition, the structure and form economic growth and economic development processes vary. Economic growth alone is the replication of a given structure. Continued economic growth does not lead to structural transformation and economic development. Ultimately, economic growth cannot occur before the infrastructure and institutional structures for economic development are in place (Brinkman, 1995).

Conclusion

In the final analysis, economic growth theories, including neoclassical growth theory, new growth theory, and modern political growth theory, explain economic growth trends in the U.S. economy and the global economy. Economic growth occurs when a nation grows extensively by using more physical, natural, or human resources or intensively by using resources more efficiently or productively. Economic growth, which is generally considered to be either extensive or intensive in nature, requires infrastructure, human resources, and organizational support (Snowdon, 2006).

Terms & Concepts

Business Climate: The combined factors, such as tax structure, public services, government regulations, labor force, and infrastructure, as that affect the profitability and experience of conducting business in a particular country or region of the world.

Business Cycle: Irregular, cyclical fluctuations found in the collective economic activity of nations that rely on business enterprises.

Competitiveness: The set of institutions, policies, and factors that determine the level of productivity.

Convergence: The tendency of poor economies to grow more rapidly than rich economies.

Developing Countries: Countries characterized by an underdeveloped industrial base, low per capita income, and widespread poverty.

Economic Growth: The quantitative measure of increase or decrease in a country’s economy.

Extensive Economic Growth: Growth scenarios in which an increase in the GDP is absorbed by a population increase without any increase in per capita income.

Fiscal Policy: The expenditures by federal, state, and local governments and the taxes levied to finance these expenditures.

Global Economy: A model economy characterized by growth of nations, both in populations and in output and consumption per capita, interdependence of nations, and international management efforts.

Globalization: A process of economic and cultural integration around the world caused by changes in technology, commerce, and politics.

Gross Domestic Product: The total market value of all goods and services produced within a country in a given period of time.

Intensive Economic Growth: Growth scenarios in which GDP growth exceeds population growth creating a sustained rise in living standards as measured by real income per capita

Monetary Policy: A tool used by the federal government to control the supply and availability of money in the economy.

Nations: Large aggregations of people sharing rules of law and an identity based on common racial, linguistic, historical, or cultural heritage; rarely act unilaterally.

Neoclassical Growth Theory: A growth model, also referred to as the exogenous growth model, which focuses on productivity growth.

New Growth Theory: A growth model, also referred to as the endogenous growth theory, which developed in the 1980s in response to criticism of the neoclassical growth theory.

Bibliography

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Suggested Reading

Alexander, W. (1997). Inflation and economic growth: Evidence from a growth equation. Applied Economics, 29, 233-238. Retrieved August 2, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=9711240575&site=ehost-live

Eicher, T., & Turnovsky, S. (1999). Non-scale models of economic growth. Economic Journal, 109, 394-415. Retrieved August 2, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=2200778&site=ehost-live

Skonhoft, A. (1997). Technological diffusion and growth among nations: The two stages of catching up. Metroeconomica, 48, 177-187. Retrieved July 27, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=10453246&site=ehost-live