Economic growth is the sustained expansion of production possibilities measured as the increase in real GDP over a given period. The economic growth rate is the annual percentage change of real GDP. It tells us how rapidly the total economy is expanding.

The standard of living depends on real GDP per person. Real GDP per person is real GDP divided by the population. It grows only if real GDP grows faster than the population grows.

The Production Function and Potential GDP

Y = A F(L, K)

The quantity of real GDP supplied, Y, depends on the quantity of labor, L, the quantity of capital, K, and the state of technology, A (total factor productivity).

This equation shows that output depends on inputs and the level of technology.

• More inputs mean more output. That is, the marginal product of labor (the increase in output generated by increased labor) and the marginal production of capital (the increase in output generated by increased capital) are both positive.
• The higher the level of technology, the more output is produced for a given level of inputs.

The law of diminishing returns: As the quantity of one input increases with the quantities of all other inputs remaining the same, output increases but by ever smaller increments. As capital per hour of labor rises, output rises (the marginal product of capital is positive) but output rises less at high levels of capital than at low levels. This is the key explanation of why the economy reaches a steady state rather than growing endlessly.

Convergence is the process of one economy catching up with another economy. According to the neoclassical growth theory, countries with a low level of capital would have a higher marginal product of capital because of diminishing returns and hence attract more investment and grow faster.

Growth in Y = Growth in technology + W_L (growth in labor) + W_C (growth in capital)

where W_L and W_C = 1 - W_L are the shares of labor and capital in GDP.

Sources of Economic Growth

There are five important sources of growth for an economy:

• Labor supply is the quantity of the work force. It is determined by population growth, the labor force participation rate, and net immigration.
• Human capital measures the quality of the labor force. Human capital acquired through education, on-the-job training, and learning-by-doing is the most fundamental source of economic growth. It is the source of increased labor productivity and technological advance.
• Physical capital results from saving and investment decisions. The accumulation of new capital increases capital per worker and labor productivity.
• Technology. Technological change - the discovery and the application of new technologies and new goods - has contributed immensely to increasing labor productivity. It is the main factor affecting economic growth in developed countries.
• Natural resources account for some of the differences in growth among countries.

Measures of Sustainable Growth

Labor productivity is the quantity of real GDP produced by an hour of labor. The growth of labor productivity depends on physical capital growth, human capital growth, and technology advances.

Potential GDP = Aggregate hours worked x Labor productivity

Potential growth rate = Long-term growth rate of labor force + Long-term labor productivity growth rate