How do economies grow?

These days, we hear again and again about the so-called "need" for economic growth. But how do countries actually grow economically? That is, why/how does their GDP increase over time?

Related, what are policies that are believed by economists to interact the most with growth? And what are these channels of interaction? I'm not looking for dogmatic answers on this part, make sure that you state the causal chain as neutral as possible and link references when possible.

• This is part of two questions. I felt that people always tried to ask these questions here (see the many questions on growth), but we shut them down as they weren't using the right words / asking the right question. I hope that these two basic questions gets some high quality answers as they are the central point of misunderstanding between "capitalists" and "anti-capitalists". – FooBar Jul 15 '15 at 6:54
• In its current form this question seems inviting to political answers. (Laissez faire is the best policy ever, no regulation leads to super high rates of growth / redistribution of wealth increases consumption and leads to greater growth, etc.) I also think that different countries (small open economies, US, undeveloped countries) need different policies, so a general / dogmatic answer might be misleading. – Giskard Jul 17 '15 at 12:13
• @denesp I agree there is some risk, but Im sure a good answer can give an overview on these different paths, while maintaining objectivity. – FooBar Jul 17 '15 at 12:19
• I'm sure that most economists will agree on the channel through which laissez faire and redistribution affect growth, they just disagree on the relevance/size of these channels. This also is directed towards your second point: Perhaps the (size of the) impact of laissez faire onto growth is different for a SOE than for the US, but the direction of the channels should be the same. I see whether I can rephrase that part such that it is clear that I rather look for a list of channels, than for the optimal policy. – FooBar Jul 17 '15 at 12:26
• @Danny I voted your answer down because it disregarded the part of the question that was displayed in italics. I did not comment because I felt you would probably reread the question and come to the same conclusion. If you disagree that is fine, you are of course entitled to your opinion. – Giskard Jul 18 '15 at 20:36

GDP is a measure of economic activity. One typical way to look at the question is the way shown in another answer. Here I want to put some assumptions in place in order to give a bit more structure.

It is widely accepted that economic output is created through capital and labor, and facilitated by technology. For the sake of answering this question, we can assume that somehow we can aggregate all the decentralized small economic activities into one aggregate economic activity. For our economy then, GDP $Y$ is produced using labor $L$, capital $K$, and technology $A$, and some sort of production function $F$.

$$Y = F(A, K,L)$$

This entails all ways that growth can happen, and I shall walk quickly through them.

Labor

When there is more work being done, we produce more. This includes both the intensive margin (each worker spending more time per week, month, year on on his job(s)), and the extensive margin (there being more workers, due to larger population).

Note that it is unlikely to get persistent growth from the intensive margin - eventually people are working as much as they can. The extensive margin, however, can give you persistent growth.

One can also think about $L$ as effective labor, in the sense that human capital also influences output. A stronger man can harvest more fields than a weak one, and a smart man can design more bridges. If workers get more skills that are useful in their economic activity, that will also stimulate growth.

Capital

When there is more machines, we can produce more, for the same amount of labor. $K$ in that equation entails both quantity and quality of machinery, similar to the human capital point.

Capital is part of economic output. Hence, in order to create GDP, we need GDP. We also need people to actually decide that saving previously earned GDP and "transforming it into capital" is better than consuming it.

Capital naturally depreciates. This is because technology may change, and hence old tools might be of less use, but also naturally due to fatigue etc. Hence, even if we don't want to grow, we still need to consistently devote a share of GDP towards investment. If we want positive growth, we need to invest further.

Technology

Technically, technology incorporates both $A$ and $F$ in the previous equation. If we have a large population, but only little capital, creating technologies that make more efficient use of labor, and need less capital, will increase growth. Regarding $A$, using technologies that allow us to produce at a higher level of efficiency we can produce a higher level of output for the same amount of inputs.

So then, what are good policies/channels?

Increase investment

Higher investment means more capital, and hence more to produce. An example policies to increase investment are decreasing capital taxation, and anything that increases the return to capital.

Increase effective labor

We cannot get persistent growth from increasing the working hour per person, although this may be a valid policy in the short run. Increasing the labor force (more immigration, higher fertility) is a second. Be cautioned, that that also means that the population gets a smaller share of the GDP, as we have more people to split the cake.

Increasing human capital hence seems like the natural way. Policies that allow people to become better at their jobs will increase growth. That could be

• better education
• training on the job
• couching of unemployed

Increase technology

This is a no-brainer, and most likely the most important driver of economic growth over the past century. In effect, many people are worried that the time of big growth is over, just because the time of big inventions and technological booms appears to be over. Policies that incentivize research and development will increase growth. Such as

• Patents (but they are a double edged sword) and anything else that will increase the returns to research
• Better education, make "research" more attractive
• Technological/research hubs, similar to silicon valley: Anything that facilitates research
• I agree that patents are a double-edged sword (i.e there are circumstances in which they might reduce innovation). Wouldn't a batter way to handle that bullet point be to say that a policy that provides "A more efficient regime of intellectual property protection" is desirable. That would make the point that intellectual property can boost innovation, whilst deferring the (difficult) question of what exactly an optimal IP regime looks like to another time. – Ubiquitous Jul 22 '15 at 17:10
• Also, it might be interesting to mention Solow (1957), who famously showed that the Solow residual (i.e. technology and education) accounted for about 87% of early 20th century US growth. Unless, that is, there is some more recent results on this. – Ubiquitous Jul 22 '15 at 17:13

You mentioned in the question that economy grow, when their GDP increase over time. Before going further one needs to understand what makes the GDP.

The question

What is the Gross Domestic Product (GDP)? and one of its answer provide some defintion and helps us to learn that GDP can be calculated as

$$GDP = C + I + X - M + P$$

where $C$ is the consumption, $I$ the investments, $X$ the exports, $M$ the imports and $P$ the public spending.

From there the evolution of the GDP over time can be analysed.

Factors influencing the evolution of the GDP

Trivially, since all those parameters are based on the price, a huge inflation will effectlively create a large growth. This is why one can often read about GDP in constant dollars (once the inflation has been corrected for). In the following the inflation will be omitted.

In this discussion, we will only consider the terms above, in brief ways, the full analysis could cover several Ph.D Thesis. We have

• Consumption ($C$): this will be affected by unemployment, conjectural situation (in "crisis", people tend to consume less), fiscal (more taxes, less consumption), and monetary (fund rates may convince people to save their money instead of spending it);
• Investment ($I$): companies are more inclined to invest, if they could increase their profit, if the perspective look good, and if they are presented with the opportunity;
• Export ($X$): if your market is competitive (quality/price), and your production amount to enough to cover the international needs, you can export goods, which will increase the GDP;
• Import ($M$): inversely, if you lack some goods (primary ressources, for example), you need to import them. That money goes to other countries and lowers your GDP;
• Public spending ($P$): the states, regions, cities or any administration spend money by buying services or products from private companies. All those are missing in $C$ and $X$. So the more the state spends, the more the GDP rises. It should be noted, particularly in the current context, that if the state spends more than what it has, problems may occur. But here is not the place for that.

So policies to create economic growth are policies that will (eventually) affect those parameters (in the "good" direction).

The problem is that most policies are not one-dimensional.

Example 1: Lowering Taxes

For example, lowering the taxes (in general), will

• help the population by providing more means for consumption (increase $C$),
• help the companies to get a surplus so they could (most of the time) choose between two paths: lower the cost of their products (and increase $C$ or $X$), or invest in a new product or new branches (increasing $I$).
• However, it will lower the potential for the state to invests (lowering $P$).

Some might argue that increasing two parameters ($C$ and $I$ or $C$ and $X$) at the cost of lowering one ($P$) is worth it. But one should see that not 100% of non-collected taxes will be spent. Some will help the population to increase their bank account, pay their mortgage (which is not productive); and companies may give higher bonuses, dividends, etc. So lowering the taxes may not increase those parameters as much as expected.

Furthermore increasing $C$ may result in the increase of $M$. If people are richer, they are more likely to import some of those famous French Wine. Worst, the government may choose to continue the public investment, increasing the debt. So in the worst case, the GDP is unaffected, and a public debt is converted in inactive wealth for both population and companies.

Example 2: Decrease of Unemployment

A second example to give an idea of the complexity of policy making. Having a lower unemployment, and more jobs in the private sector will probably improve the GDP.

• Indeed, the public money can be more directed to investments (increase of $P$) than taking care of social issues (unemployment income, health help, training and schooling, etc.),
• and that will increase the taxes they perceive, so they have more money available to spend.
• People receiving higher salaries (employed rather than at home on national help), are more likely to consume (increasing $C$), which will increase the imports ($M$), but also increase the sales of your own companies.
• The extra work, means your companies will produce more and/or better, which will help to increase the exports ($X$), and they can then secure a given surplus, which can be used to invest ($I$) in expanding their business (which creates more employment).

That sounds wonderful, doesn't it? But now the tricky part. How do you create employment? That's where there aren't any single answer, but several depending on dogmatic view. Just to summarise two "classic" views,

• lower the taxes on the companies, such that they get more money to invest, and expand their business, by creating jobs. This is associated with classic liberals, neo-conservative and generally right-wing politicians. The problem, as we have seen above, is that not all the money invested (by means of lowering income) by the state will be used for investment, and not all of it in your country. And it either lowers $P$ or increase the debt (or both).
• increase the public spending, for examples building roads, employing more people, etc. This directly creates more jobs, usually quite low income, who are more likely to spend all of it. As a consequence $C$ should increase, and thus the profits of the companies should increase in consequence, starting a virtuous circle. This is a more direct way. However it is very expensive, as you start to invest, you need to either have savings, or more likely increase the public debt.

If your market is rigid, that is to say it does not adapt very fast, you might be spending a lot of money before any effect occurs. And if your companies aren't competitive, you will increase considerably the imports ($M$). This approach is more associated with socialists/"liberals"/... centre-left politicians.

Both approaches are very nice in theory but both have been shown to fail at times.

I think that at this point, the complexity of policies is understood, and it is also understood that full analysis could fill in several books (and there are a few good ones on the market).

Just another note, GDP of most (all?) countries is measured at regular intervals (monthly/every trimester). If the change/increase of GDP during two consecutive trimesters (meaning 6 months) is negative (meaning if the GDP lowers for 6 months in a row), we talk about a recession.

• I've reformatted the second half a bit, it was two very long blocks of text - feel free to adapt whatever change you dont like – FooBar Jul 21 '15 at 12:26

To answer your first question (how do economies grow): By creating surplus value. I always wondered why surplus value was not studied more deeply because it explains the paradox of how 1 + 1 could equal 3. Now, how you create/increase surplus value is a topic that I cannot explain in few words (so, no chance for me to get the bounty).

The one party things: we need growing economics because we want to get a better and better life over time. The mechanics of inflation and growing markets creates more flexibility for new products and prevents deflation.

The other party thinks more the way we could also have products stay alive 20 years (instead to planned obsolescence) and a country can have a working cycle of economics growing with the number of people instead of inflation.

Both theories have much deeper arguments and I only added both points of view to stay neutral. It shouldn't place one of them into a bad corner.

Edit 2: Economics grow by the "speed" money cycles comparing to the previous period. The worth/costs of goods and services (reason for cycling money) is affected by different factors like inflation and production factors (human, ground, ...). Explaining this the easy way will not be complete - the complete way would be to much. Finally explaining economic growing is a question of perspective and motivation. So measuring economic growing has goals: Govern, comparing, deciding.

• -1: This question is a technical one about how growth happens, not about why and whether it is appreciated. – FooBar Jul 19 '15 at 17:48
• thanks for clarification. So I added a link to a chapter of Wikipedia. There are different explanations how it works. but in general the "why" is the "how". If you read Wikipedia, you maybe agree. – Danny Jul 19 '15 at 18:04
• @Danny I think by "broke planed" you mean planned obsolescence. Can you please research your answer a bit more thoroughly? While I understand some of your arguments you should try to make your answer crystal clear even to people who have not heard about these things. This means your thought process should be very clear and you should refer to data, research and concepts wherever you can. Mind that something that is obvious to you is probably not obvious to others. – Giskard Jul 19 '15 at 18:33
• @Danny your answer should strive to be like this one: economics.stackexchange.com/questions/5913/… (Except you don't need to start yours by agreeing with me.) – Giskard Jul 19 '15 at 18:37
• If I may, your main points (first paragraphs) are more about the why than the how. For that your answer would probably fit better in the related question. Trying to answer questions is always a good idea, but due to the educational aim stated by FooBar, the answer should try to aim to be simplified for people unfamiliar with the concepts. Just my feeling, I haven't been here too long neither. – clem steredenn Jul 21 '15 at 12:30

GDP is a measure of new value created in the system. It is a flow magnitude. That statement is supposed to convey the notion of it adding something new to something else that is already there ie to a stock of already present values. When GDP grows, the economy is expanding its value stock.

'Value', as it were, is composed of two constituent parts; there is a part related to price and a part related to quantity. Also, note that value should be treated as a plural form, in the sense that, there are a lot of things of value; the sum of those values is what constitutes the total value available at a point in time, for a given economy.

Treating GDP as a sum of values, allows us to decompose the change to its magnitude:

$ΔY = ΔY_1 + ΔY_2 + ... + ΔY_n$

(obviously, $Y$ denotes (the value of) GDP while $Y_i$ denotes the value of GDP's component $i$)

Further decomposition of the change in the $Y_i$'s yields:

$ΔY=(ΔP_1Q_1+P_1ΔQ_1+ΔP_1ΔQ_1)+...+(ΔP_nQ_n+P_nΔQ_n+ΔP_nΔQ_n)$

From a first glance to the change formula shown above, one should notice that the total change for every value component of GDP ($Y_i$), can be attributed either to a change in price ($ΔP_i>0$) or to a change in quantity ($ΔQ_i$>0) or to a change in both ($ΔP_i>0$ and $ΔQ_i>0$).

When only the price changes, for a single component ie when $ΔP_i>0$ and $ΔQ_i=0$, a change in the value of that component is effectively an inflationary change. On the other hand, when the value of a component changes due to changes in the underlying quantity ie when when $ΔP_i=0$ and $ΔQ_i>0$, we get a real growth effect.

There are a few things to notice in this simple accounting exercise. The first has to do with the signs of the changes we are considering so far. Although we have talked about positive changes in either the price component or the quantity component, there is really no reason not to consider the case where these changes are actually negative.

A negative change in the price part is equivalent to valuing the same quantity (assuming $ΔQ_i=0$) of component $i$ for less. Similarly, when the quantity of component $i$ drops (assuming $ΔP_i=0$), there is less of the actual commodity or service $i$ available-in this sense, the economy is poorer in real terms. In the former case, the economy was simply cheaper as far as the $i$ component was concerned.

Another thing to consider, regarding the exposition so far, is that what happens to the value of component $i$ (whether it increases, decreases or stays the same) is not disconnected from what happens to the rest of the components of GDP. This means that frequently (but not always) it is the case that positive or negative changes in the price or quantity components of some of the constituent parts of GDP is accompanied by similar movements in the value of most other components of GDP.

Effectively, that means that changes in GDP ($ΔY$) are not happening because a few components suddenly jumped/dropped in price or quantity terms ($ΔP_i>0$ and/or $ΔQ_i>0$ for few $i$'s) at the same time. Persistent changes in GDP are due to persistent changes in most, if not all, the constituent components.

One more thing to consider is the fact that, most of the time, the parts that change are neither prices nor quantities in isolation but both of them in tandem. That poses the very real problem of distinguishing which part of the newly created value (GDP) is due to the economy having more of some commodities or services ($ΔQ_i>0$ for some $i$'s) and which part is due to price changes ($ΔP_j>0$ for some $j$'s). Note that in all likelihood some of the $i$'s and $j$ are the same. It is because of this eventuality that we make the distinction between real and nominal GDP. Real growth is related to increases in the available quantities of commodities and services while nominal growth might be underlined by inflationary pressures.

A final point to consider is that $ΔY$ ie the change in the value of GDP can come from another direction. Until now, we were considering the changes that were related to components $Y_i$ where $i=1,2,...,n$. Well, it so happens that $n$ is not constant but changes with time.

For some periods of time the number of available commodities and services might be equal to $n_1$ while for other periods the value of $n$ may be equal to $n_2$ and still other times it might be equal to $n_3$. What is important to understand is that it could be the case that $n_1<n_2<n_3$ but that is not necessary how they should rank. It is just the case that when $n$ increases, the value of GDP increases also and vice-versa (obviously, there is a ceteris paribus clause of constant prices and quantities for all the 'old' commodities and services).

When GDP changes in that manner, the change can be attributed to the introduction of new commodities and services. Generally speaking, when talking about GDP growth, what is tacitly understood is that $n=const$. The introduction of new commodities and services is generally attributed to the effects of technological change.

'Technological change' in economics is an all encompassing notion that fuses scientific progress with managerial and organizational changes in the way-of-doing-business. In that sense, the change in GDP that is attributed to technological change (what is frequently dubbed total factor productivity increases) might be due to the introduction of new commodities or services or the introduction of a better way of doing business but it might also be attributed to relative price changes due to innovations that conserve on (relatively) scarce productive resources.

Innovations that change relative prices effectively act upon the cost structure of some productive processes and if they are too disruptive they can also change the relative income distribution of the affected factors of production. These effects mean that innovations might lower the price component of (some) $Y_i$'s but it is not clear what will happen to the quantity component of those
$Y_i$'s (we abstract from any substitution and/or complementary effects between $Y_i$'s).

Having covered all this ground, we can say that economies grow in real terms when, on average, modest price increases are accompanied by strong quantity increases. Also, these movements should be such for the majority of commodities and services. Additionally, growth can come in the form of changing the cost structure of available production processes without causing incommensurate income disruption or, ultimately, from the expansion of the number of available commodities and services.