Economic Growth | Explainer | Education (2024)

What is Economic Growth?

Economic growth refers to an increase in the size ofa country's economy over a period of time. The sizeof an economy is typically measured by the totalproduction of goods and services in the economy,which is called gross domestic product (GDP).

Economic growth can be measured in ‘nominal’or ‘real’ terms. Nominal economic growth refers tothe increase in the dollar value of production overtime. This includes changes in both the volume ofproduction and the prices of goods and servicesproduced. Economists normally talk about realeconomic growth – that is, increases in the volumeproduced only, which takes away the effect ofprices changing. This is because it better reflectshow much a country is producing at a given time,compared with other points in time.

How is GDP Measured?

To measure GDP each quarter, the Australian Bureauof Statistics (ABS) collects data from households,companies and government agencies. The ABSthen calculates GDP in three different ways, lookingseparately at information about production (P),income (I) and expenditure (E). The three definitionsof GDP are:

• GDP(P): total value added from goods and services produced
• GDP(I): total income generated by employees and businesses (plus taxes lesssubsidies)
• GDP(E): total value of expenditure by consumers, businesses and governments on finalgoods and services.

These are three different ways to estimate the samething. In practice, different results can be obtainedbecause there are never enough data to build acomplete picture of the economy. Many economicactivities have to be estimated and measurementerrors arise. In Australia, the ABS and economistsgenerally focus on the average of the threemeasures – GDP(A).

Box: Real versus Nominal GDP – An Example

Nominal GDP is the dollar value of the goods and services produced in atime period, whichdepends on the volume of what was produced and the pricesof what was produced. Real GDPcaptures only the volume of what was produced.

The calculation of real and nominal economic growth can be shown using an example ofaneconomy that only produces one good - let's say it is apples.

Suppose that in year 1, the volume of apples produced was 100kg and the price ofapples was$2 per kg, so the total value of production was $200 (100 x $2). In year 2, 104kg ofapples wereproduced and the price was $2.05 per kg, so the total value of production was$213.20 (104 x $2.05).

In this example, nominal GDP growth (6.6 per cent) is more than real GDP growth (4per cent)because it includes the increase in prices over the period. (The sum of the growthrates of real GDPand prices is close to, but not exactly equal to, the growth rate of nominal GDP.)

See Also

Capital Goods: Types, Examples, vs. Consumer GoodsWhat Is Capital? Definition, Types, and Examples - Pareto LabsWhy do banks need to hold capital?Which capital would you consider the best — land, labour, physical capital and human capital? Why?

What's not Captured in GDP Statistics?

While GDP is the main measure of economic growth,it doesn't capture everything that adds value to theeconomy. One example is that caring for children isnot included in GDP if carried out by their parents(but is if it is done by a paid childcare worker).

GDP doesn't capture broader aspects of economicwelfare of the nation's population. For example, if GDProse by 2 per cent one year, but the population grewby 4 per cent, then average GDP per person wouldhave decreased. Similarly, GDP doesn't tell us anythingabout how evenly national income is split across thepopulation. Income may have increased for everyone,or may have been concentrated in certain groups.

Finally, there are things that raise GDP but don'tmake the country better off. One example isthe initial spending to replace buildings andinfrastructure after a natural disaster, which boostsmeasures of economic growth.

What is Aggregate Demand?

Aggregate demand (AD), like GDP(E), refers tothe total level of spending in the economy.Consequently, when aggregate demand ismeasured it is the same as GDP(E). Aggregatedemand includes household spending (also calledconsumption, C), investment by businesses andhouseholds (I), spending by the government (G)and net spending from overseas (X-M).

Consumption

Household consumption (C) refers to spendingby households on things like rent, groceries andutilities. It makes up the largest share of aggregatedemand. The level of consumption by eachhousehold is largely dependent on their level ofincome (Y). Household income that is not spent, issaved (S).

When household income increases, householdspending usually increases as well. The amount ofextra consumption for an extra dollar of income iscalled the marginal propensity to consume (MPC).

Box: The Simple Multiplier

The simple expenditure multiplier refers to how much additional GDP results from an initialchange in expenditure. An initial increase in expenditure can lead to a larger increase in economicoutput because spending by one household, business or the government is income for anotherhousehold, business or the government. For example, suppose a business decides to build awind farm in a small town and spends $10 million in the first year. That $10 million would go toengineers and others involved in constructing the wind farm. If their MPC is 0.8, those peoplewill spend $8 million on goods and services and save $2 million. The businesses and individualsreceiving that $8 million will in turn spend $6.4 million and so on. So the initial $10 millioninvestment results in a much larger increase in GDP. The total amount of additional GDP can becalculated using the simple multiplier (k). In this example, the multiplier is 5 (that is, 1/(1–0.8)), suchthat the initial $10 million investment results in $50 million in additional GDP.

A number of factors other than current incomeare also important for household spending. Ifhouseholds expect to have higher income inthe future, household spending will generallyincrease. Similarly, if household wealth increases,for example, due to rising housing prices, there willlikely be an increase in household spending.

Investment

In economic terms, investment refers to spendingby businesses and households that increasesthe economy's capacity to produce goods andservices. This includes building new houses andoffices, purchasing machinery, constructingroads and other physical infrastructure, as well aspurchasing computer software and undertakingresearch and development. The level of investmentin the economy is determined by a range offactors including interest rates, expected profits,government policy and changes in technology.

Government spending

Governments spend money on hospitals, schools,defence, roads, transport and more. Governmentspending can be either structural or cyclical.Structural spending occurs regardless of the stateof the economy; it includes, for example, spendingon education, health services and defence. Otherspending is more cyclical. For example, in aneconomic downturn when the unemploymentrate has increased, there will be more governmentspending on programs to support theunemployed.

Net Exports

Net exports are made up of the spending onexports minus spending on imports. The spendingof imports is subtracted from that on exportsbecause GDP measures production within acountry, and imports are produced overseas.

Exports refer to goods and services that Australianbusinesses sell to other businesses, householdsand governments overseas. The level of ourexports is generally higher when growth inour major trading partners is strong becauseour exports are used in production in theseeconomies. Australia's exports of iron ore andcoal to China have grown rapidly over the pastdecade, as they are inputs into steel production inChina. Steel has been used in the construction ofapartment buildings and infrastructure in China,as the economy has grown strongly. Australianexports are also generally higher when theAustralian dollar exchange rate is low because itbecomes cheaper for other economies to buyAustralian goods and services.

Imports are goods and services that Australianbusinesses, households and the governmentbuy from overseas. The level of imports dependson the strength of the other componentsof aggregate demand. This is because somehousehold consumption goods and services,investment and government purchases areimported. For example if household consumptionis strong, part of this would be imported, soimports would be stronger too. The level ofimports also depends on the Australian dollarexchange rate. Imports are generally higher whenthe Australian dollar exchange rate is stronger,because it becomes cheaper to buy goods andservices from overseas.

What Factors Affect Aggregate Supply?

Aggregate supply refers to the total output ofgoods and services in the economy. Aggregatesupply is determined by the level of inputsavailable to produce goods and services, andhow efficiently these inputs are used. The maininputs into production are labour and capital. Theamount of labour available depends on how manypeople there are in the economy (population)and how many of them are working or wouldlike to work (the participation rate). Capital refersto things that are used in production. Capital canbe tangible, such as buildings, machinery andequipment, or intangible, such as research anddevelopment. Productivity refers to how muchcan be produced with a given set of inputs.

Productivity growth occurs when we find ways toproduce more with a given amount of labour andcapital. Productivity growth is often associatedwith increases in efficiency and advances intechnology. Increases in aggregate supply increasethe productive capacity of the economy (usuallycalled potential output).

Box: Contributions to GDP growth

Each of the components of aggregate demand contribute to growth in GDP. The size of thecontribution to growth is determined by both the size of the component and its growth rate. Forexample, consumption accounts for more than half of GDP and tends to grow at a steady rate,so it almost always makes a large contribution to GDP growth. Smaller components can havemore volatile growth, and have large effects on GDP growth. Mining investment is one examplewhich accounts for a small share of GDP but has recorded large swings over the past decadeassociated with the resources boom and its slowdown, so it has made large contributions to, andsubtractions from, growth at different points in time.

Trends in the Business Cycle

The business cycle refers to fluctuations ineconomic growth relative to growth in potentialoutput. Monetary policy is one tool used tosmooth fluctuations in the business cycle (seeExplainer: What is Monetary Policy?).

In the upswing stage of the business cycle, thereis usually strong growth in GDP and employment.As a result, the unemployment rate declinesand inflation starts to increase. The period of2005–08 could be characterised as an upswing,as high commodity prices and mining investmentcontributed to strong economic growth. As theeconomy began to reach capacity constraints,wages growth and inflation began to increase.Around this time, the Reserve Bank increased thecash rate to put downward pressure on inflation.

In 2008, the global financial crisis put downwardpressure on economic activity. Economic growthin Australia slowed, and we experienced othercharacteristics associated with a downturn. Growthin GDP and employment declined, and theunemployment rate increased. During this period,the cash rate was reduced to stimulate demandand support the economy.