What Is Economic Growth? (2024)

What Is Economic Growth? (1)

How Does Economic Growth Work?

Economic growth is the increase in the value of an economy's goods and services, which creates more profit for businesses. As a result, stock prices rise. That gives companiescapitalto invest and hire more employees.

As more jobs are created, incomes rise. Consumers have more money to buy additional products and services, and purchases drive higher growth. For this reason, all countries want positive economic growth. This makes economic growth the most-watched economic indicator.

Example of Economic Growth

As an example, take a look at the U.S. economy in the 1980s. After two economic contractions in the first three years of the decade, the economy began to boom. Almost 19 million jobs were added over the decade, although unevenly. Sectors such as manufacturing and mining lost jobs, but others, such as service and retail, expanded rapidly. More women entered the workforce during the 1980s, too. This soaring productivity plus a weakening dollar abroad helped U.S. companies meet the increased demand for exports and revenue rose accordingly.

By the decade's end, gross domestic product(GDP) had skyrocketed from $2.8 trillion in 1980 to $5.5 trillion by 1989.

How To Measure Economic Growth

Gross domestic productis the best way to measure economic growth because it takes into account thecountry's entire economic output. GDP includes all goods and services that businesses in the country produce for sale. It doesn't matter whether they are sold domestically or overseas.

Note

GDP measures final production. It doesn't include the parts that are manufactured to make a product. GDP includesexportsbecause they are produced in the country.Importsare subtracted from economic growth.

Most countries measure economic growth each quarter.

The most accurate measurement of growth isreal GDP, which removestheeffects of inflation. TheGDP growth rateuses real GDP.

The World Bank uses gross national income instead of GDP to measure growth. It includes income sent back by citizens who are working overseas. That is a critical source of income for manyemerging market countries such as Mexico. Comparisons of GDP by country will understate the size of these countries' economies.

Top 10 Countries by GDP
CountryGDP (in millions)
United States$22,996,100.00
China$17,734,062.65
Japan$4,937,421.88
Germany$4,223,116.21
United Kingdom$3,186,859.74
India$3,173,397.59
France$2,937,472.76
Italy$2,099,880.20
Canada$1,990,761.61
South Korea$1,798,533.92

What GDP Does (and Does Not) Include

GDP is not the only measure of economic growth. For starters, it doesn't includeunpaid work, such as dependent care or volunteer work. It also doesn't include illegal,black-market activities.

Gross domestic product also does not account for environmental costs. For example, the price ofplastic seemscheap because it doesn't include the cost of disposal.As aresult, GDP doesn't measure how these costsaffectthe well-being of society at large.

Note

A country will improve itsstandard of livingwhenit factors in environmental costs.

Similarly, societies only measure what they value—and they only value what they measure. For example,Nordic countriesrank high in the World Economic Forum'sGlobal Competitiveness Report.Their budgets focus on the drivers of economic growth, which are world-class education, social programs, and a high standard of living. These factors create a skilled and motivatedworkforce.

These countries have a high tax rate. But they use therevenuesto invest in the long-term building blocks of economic growth.

This economic policy contrasts with that of the United States. The U.S. usesdebt to finance short-term growth through boosting consumer and military spending. That's because these activities do show up in GDP, which the U.S. uses to measure its economic growth.

Note

RianeEisler's book,“The Real Wealth of Nations,” proposes changes to the U.S. economic system by giving value to activities at the individual, societal, and environmental levels.

The Phases of Economic Growth

Analysts watch economic growth to discoverwhat stage of thebusiness cyclethe economy is in. The best phase isexpansion. This is when the economy is growing in a sustainable fashion. If growth is too far beyond a healthy growth rate, it overheats. That creates anasset bubble, which is what happened to the housing sector in 2005-2006. As too much money chases too few goods and services,inflationkicks in. This is the "peak" phase in the business cycle.

At some point, confidence in economic growth dissipates. When more people sell than buy, the economycontracts. When that phase of the business cycle continues, it becomesarecession. An economic depression is a recession that lasts for a decade. The only time this happened was duringthe Great Depression of 1929.

The chart below shows the different phases of the U.S. economy.

Inflation in the U.S. topped 9% in June 2022, stoking fears of a recession.

Causes of U.S. Growth

The United States has an abundance of the four factors of production. These are land/natural resources, labor, capital equipment, and entrepreneurship.

Land and natural resources: The United States’ large landmass compares to those ofRussia, Canada, and Australia. But it has more natural resources than these countries. The best of these are:

  • Tillable soil in the Great Plains often called the breadbasket of the world
  • A temperate climate
  • Freshwater lakes and rivers
  • Large deposits of oil, coal, and natural gas

Canada and Russia are thwarted by a cold climate. Australia is dry.

Labor: The U.S. labor force is large, skilled, and mobile. It responds quickly to changing business needs. The large and diverse population provides a home-grown test market. It gives domestic companies experience in knowing what consumers want. This has given the United States acomparative advantagein producing consumer products. As a result, almost 70% of what thecountry produces is for personal consumption.

Capital equipment: U.S. companies have an advantage in exporting, and as a result, the United States is the world's second-largest exporter.This has allowed the country to excel in producing the fourth factor of production, capital equipment. These include computers, semiconductors, and medical equipment. It also includesindustrial machinery and equipment.

Entrepreneurship: The U.S. services industry is also innovative. The most successful industries arefinancial services, health care, and intellectual property such as computer software.

Ways to Spur Economic Growth

If a country is not blessed with the factors of production, it must find other ways to spur growth. Governments want to increase growth because it increasestax revenue. Growth allows businesses to hire workers, increasing their income. When people feel prosperous, they reward political leaders by re-electing them.

The government stimulates growth withexpansive fiscal policy. It either spends more, cuts taxes, or both. Since politicians want to get re-elected, they use expansive fiscal policy to stimulate the economy.

But expansive fiscal policy is addictive. If the government keeps spending more and taxing less, it leads todeficit spending. It works for a while but eventually leads to higher debt levels. In time, as thedebt-to-GDP ratioapproaches 100%, it slows economic growth. Foreign investors stop investing funds in a country with a high debt ratio. They worry they won't get repaid or that the money will be worth less.

Governments should then be careful with expansivefiscal policy and should only use it when the economy is in contraction or recession. When the economy is growing, its leaders should cut back on spending and raise taxes. This conservative fiscal policy ensures that economic growth will remain sustainable.

A nation's central bank can also spur growth with monetary policy. It can increase themoney supply by lowering interest rates. Banksmake borrowing for cars, college, and homes less expensive. They also reducecredit card interest rates. All of these boostconsumer spending and economic growth.

Key Takeaways

  • Economic growth is the increase in the value of an economy's goods and services over time.
  • Real gross domestic productis the best way to measure economic growth, because it removes the effects of inflation.
  • The government stimulates growth withexpansive fiscal policy by spending more or cutting taxes.
  • Over time, expansive fiscal policy can lead to deficit spending, higher debt levels, and slowing economic growth.

Frequently Asked Questions (FAQs)

Why is economic growth important?

Economic growth increases a nation's prosperity. Prosperous nations are better able to care for their citizens and raise their standard of living.

Which factors contribute to economic growth?

The four factors that drive economic growth are natural resources, labor, capital equipment, and entrepreneurship. The U.S. has all four in abundance.

Which policies contribute to economic growth?

Expansive fiscal policy and monetary policy are both ways to spur economic growth. With an expansive fiscal policy, the government spends more, taxes less, or both. Monetary policy is set by a nation's central bank. In the U.S., the Federal Reserve sets monetary policy to try to maintain sustainable growth, using tactics such as raising or lowering interest rates to influence economic growth.

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Sources

The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.

  1. U.S. Bureau of Labor Statistics. "The 1980s: A Decade of Job Growth and Industry Shifts."

  2. U.S. Bureau of Economic Analysis. "Table 1.—Gross Domestic Product—Continued."

  3. U.S. Bureau of Economic Analysis. "Table 1.—Gross Domestic Product."

  4. Congressional Research Service. "Introduction to the U.S. Economy: GDP and Economic Growth."

  5. American Institute for Economic Research. "Your Guide to Understanding Real vs. Nominal GDP."

  6. The World Bank. "Why Can't I Find Estimates of Gross National Product (GNP)?"

  7. The World Bank. "GDP (Current US$)."

  8. World Economic Forum. "Global Competitiveness Report Special Edition 2020: How Countries Are Performing on the Road to Recovery."

  9. Riane Eisler. "The Real Wealth of Nations: Creating a Caring Economics." Berrett-Koehler Publishers, Inc., 2007.

  10. Jane Dokko,Brian Doyle,Michael T. Kiley, Jinill Kim,Shane Sherlund,Jae Sim, andSkander Van den Heuvel. "Monetary Policy and the Housing Bubble," Finance and Economics Discussion Series (FEDS).

  11. U.S. Bureau of Labor Statistics. "Consumer Price Index Summary."

  12. University of Minnesota Libraries. "Principles of Economics: 2.1 Factors of Production."

  13. Federal Reserve Bank of St. Louis. "Shares of Gross Domestic Product: Personal Consumption Expenditures."

  14. Statista. "Leading Export Countries Worldwide in 2020."

  15. Economics and Statistics Administration. "Intellectual Property and the U.S. Economy: Industries in Focus," Page 7.

  16. Federal Reserve Bank of St. Louis. "Debt-to-GDP Ratio: How High Is Too High? It Depends."

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