3.13: Economic Growth

Economic Growth

The size of a nation's economy is commonly expressed as its gross domestic product (GDP), which measures the value of the output of all goods and services produced within the country in a year. GDP is measured by taking the quantities of all goods and services produced, multiplying them by their prices, and summing the total. Since GDP measures what is bought and sold in the economy, it can be measured either by the sum of what is purchased in the economy or what is produced.

Universal Generalizations

• The ability of the economy to produce output determines its growth.
• Economic growth is one of the seven major goals of the U.S. economy.
• Domestic economic growth can also impact foreign nations that the U.S. trades with.
• Economic growth can raise the standard of living, lessen the burden of government, boost foreign trade, and solve domestic problems.

Guiding Questions

1. How are the factors of production impacted by the growth of GDP?
2. What element is most necessary for economic growth? Why?
3. Due to changes in population, how is long-term GDP measured?

Tracking Real GDP over Time

When news reports indicate that “the economy grew 1.2% in the first quarter,” the reports are referring to the percentage change in real GDP. By convention, GDP growth is reported at an annualized rate: Whatever the calculated growth in real GDP was for the quarter, it is multiplied by four when it is reported as if the economy were growing at that rate for a full year.

Real GDP is important because it is highly correlated with other measures of economic activity, like employment and unemployment. When real GDP rises, so does employment.

The most significant human problem associated with recessions (and their larger, uglier cousins, depressions) is that a slowdown in production means that firms need to lay off or fire some of the workers they have. Losing a job imposes painful financial and personal costs on workers, and often on their extended families as well. In addition, even those who keep their jobs are likely to find that wage raises are scanty at best—or they may even be asked to take pay cuts.

Table 1 lists the pattern of recessions and expansions in the U.S. economy since 1900. The highest point of the economy, before the recession begins, is called the peak; conversely, the lowest point of a recession, before a recovery begins, is called the trough. Thus, a recession lasts from peak to trough, and an economic upswing runs from trough to peak. The movement of the economy from peak to trough and trough to peak is called the business cycle. It is intriguing to notice that the three longest trough-to-peak expansions of the twentieth century have happened since 1960. The most recent recession started in December 2007 and ended formally in June 2009. This was the most severe recession since the Great Depression of the 1930’s.

Trough	Peak	Months of Contraction	Months of Expansion
December 1900	September 1902	18	21
August 1904	May 1907	23	33
June 1908	January 1910	13	19
January 1912	January 1913	24	12
December 1914	August 1918	23	44
March 1919	January 1920	7	10
July 1921	May 1923	18	22
July 1924	October 1926	14	27
November 1927	August 1929	23	21
March 1933	May 1937	43	50
June 1938	February 1945	13	80
October 1945	November 1948	8	37
October 1949	July 1953	11	45
May 1954	August 1957	10	39
April 1958	April 1960	8	24
February 1961	December 1969	10	106
November 1970	November 1973	11	36
March 1975	January 1980	16	58
July 1980	July 1981	6	12
November 1982	July 1990	16	92
March 2001	November 2001	8	120
December 2007	June 2009	18	73

U.S. Business Cycles since 1900 (Source: http://www.nber.org/cycles/main.html)

A private think tank, the National Bureau of Economic Research (NBER), is the official tracker of business cycles for the U.S. economy. However, the effects of a severe recession often linger on after the official ending date assigned by the NBER.

Over the long term, U.S. real GDP has increased dramatically. At the same time, GDP has not increased the same amount each year. The speeding up and slowing down of GDP growth represents the business cycle. When GDP declines significantly, a recession occurs. A longer and deeper decline is a depression. Recessions begin at the peak of the business cycle and end at the trough.

Is China Going to Surpass the United States in Terms of Standard of Living?

As shown in Table 2, China has the second largest GDP of the countries: $12,406 compared to the United States’ $16,245. Perhaps it will surpass the United States, but probably not any time soon. China has a much larger population so that in per capita terms, its GDP is less than one fifth that of the United States ($9,162 compared to $51,706). The Chinese people are still quite poor relative to the United States and other developed countries. One caveat: For reasons to be discussed shortly, GDP per capita can give us only a rough idea of the differences in living standards across countries.

The high-income nations of the world—including the United States, Canada, the Western European countries, and Japan—typically have GDP per capita in the range of $20,000 to $50,000. Middle-income countries, which include much of Latin America, Eastern Europe, and some countries in East Asia, have GDP per capita in the range of $6,000 to $12,000. The low-income countries in the world, many of them located in Africa and Asia, often have GDP per capita of less than $2,000 per year.

Video: Is China the Next Superpower?

How Well GDP Measures the Well-Being of Society

The level of GDP per capita clearly captures some of what we mean by the phrase “standard of living.” Most of the migration in the world, for example, involves people who are moving from countries with relatively low GDP per capita to countries with relatively high GDP per capita.

“Standard of living” is a broader term than GDP. While GDP focuses on production that is bought and sold in markets, the standard of living includes all elements that affect people’s well-being, whether they are bought and sold in the market or not. To illuminate the gap between GDP and standard of living, it is useful to spell out some things that GDP does not cover that are clearly relevant to the standard of living.

Limitations of GDP as a Measure of the Standard of Living

While GDP includes spending on recreation and travel, it does not cover leisure time. Clearly, however, there is a substantial difference between an economy that is large because people work long hours and an economy that is just as large because people are more productive with their time so they do not have to work as many hours. The GDP per capita of the U.S. economy is larger than the GDP per capita of Germany, as was shown in Table 2, but does that prove that the standard of living in the United States is higher? Not necessarily, since it is also true that the average U.S. worker works several hundred hours more per year more than the average German worker. The calculation of GDP does not take the German worker’s extra weeks of vacation into account.

While GDP includes what is spent on environmental protection, healthcare, and education, it does not include actual levels of environmental cleanliness, health, and learning. GDP includes the cost of buying pollution-control equipment, but it does not address whether the air and water are actually cleaner or dirtier. GDP includes spending on medical care but does not address whether life expectancy or infant mortality have risen or fallen. Similarly, it counts spending on education but does not address directly how much of the population can read, write, or do basic mathematics.

GDP includes production that is exchanged in the market, but it does not cover production that is not exchanged in the market. For example, hiring someone to mow your lawn or clean your house is part of GDP, but doing these tasks yourself is not part of GDP. One remarkable change in the U.S. economy in recent decades is that, as of 1970, only about 42% of women participated in the paid labor force. By the second decade of the 2000s, nearly 60% of women participated in the paid labor force according to the Bureau of Labor Statistics. As women are now in the labor force, many of the services they used to produce in the non-market economy like food preparation and child care have shifted to some extent into the market economy, which makes the GDP appear larger even if more services are not actually being consumed.

GDP has nothing to say about the level of inequality in society. GDP per capita is only an average. When GDP per capita rises by 5%, it could mean that GDP for everyone in the society has risen by 5%, or that of some groups has risen by more while that of others has risen by less—or even declined. GDP also has nothing, in particular, to say about the amount of variety available. If a family buys 100 loaves of bread in a year, GDP does not care whether they are all white bread, or whether the family can choose from wheat, rye, pumpernickel, and many others—it just looks at whether the total amount spent on bread is the same.

Likewise, GDP has nothing much to say about what technology and products are available. The standard of living in, for example, 1950 or 1900 was not affected only by how much money people had—it was also affected by what they could buy. No matter how much money you had in 1950, you could not buy an iPhone or a personal computer.

In certain cases, it is not clear that a rise in GDP is even a good thing. If a city is wrecked by a hurricane, and then experiences a surge of rebuilding construction activity, it would be peculiar to claim that the hurricane was therefore economically beneficial. If people are led by a rising fear of crime, to pay for installation of bars and burglar alarms on all their windows, it is hard to believe that this increase in GDP has made them better off. In that same vein, some people would argue that sales of certain goods, like pornography or extremely violent movies, do not represent a gain to society’s standard of living.

Does a Rise in GDP Overstate or Understate the Rise in the Standard of Living?

The fact that GDP per capita does not fully capture the broader idea of the standard of living has led to a concern that the increases in GDP over time are illusory. It is theoretically possible that while GDP is rising, the standard of living could be falling if human health, environmental cleanliness, and other factors that are not included in GDP are worsening. Fortunately, this fear appears to be overstated.

In some ways, the rise in GDP understates the actual rise in the standard of living. For example, the typical workweek for a U.S. worker has fallen over the last century from about 60 hours per week to less than 40 hours per week. Life expectancy and health have risen dramatically, and so has the average level of education. Since 1970, the air and water in the United States has generally been getting cleaner. New technologies have been developed for entertainment, travel, information, and health. A much wider variety of basic products like food and clothing are available today than several decades ago. Because GDP does not capture leisure, health, a cleaner environment, the possibilities created by new technology, or an increase in variety, the actual rise in the standard of living for Americans in recent decades has exceeded the rise in GDP.

On the other side, rates of crime, levels of traffic congestion, and inequality of incomes are higher in the United States now than they were in the 1960s. Additionally, a substantial number of services that used to be provided, primarily by women, in the non-market economy are now part of the market economy that is counted by GDP. By ignoring these factors, GDP would tend to overstate the true rise in the standard of living.

GDP is Rough, but Useful

A high level of GDP should not be the only goal of macroeconomic policy or government policy more broadly. Even though GDP does not measure the broader standard of living with any precision, it does measure production well and it does indicate when a country is materially better or worse off in terms of jobs and incomes. In most countries, a significantly higher GDP per capita occurs hand in hand with other improvements in everyday life along with many dimensions, like education, health, and environmental protection.

No single number can capture all the elements of a term as broad as “standard of living.” Nonetheless, GDP per capita is a reasonable, rough-and-ready measure of the standard of living.

How is the Economy Doing? How Does One Tell?

To determine the state of the economy, one needs to examine economic indicators, such as GDP. To calculate GDP is quite an undertaking. It is the broadest measure of a nation’s economic activity and we owe a debt to Simon Kuznets, the creator of the measurement, for that.

The sheer size of the U.S. economy as measured by GDP is huge—as of the third quarter of 2013, $16.6 trillion worth of goods and services were produced annually. Real GDP informed us that the recession of 2008–2009 was a severe one and that the recovery from that has been slow, but is improving. GDP per capita gives a rough estimate of a nation’s standard of living.

GDP is an indicator of a society’s standard of living, but it is only a rough indicator. GDP does not directly take account of leisure, environmental quality, levels of health and education, activities conducted outside the market, changes in inequality of income, increases in variety, increases in technology, or the (positive or negative) value that society may place on certain types of output.

Comparing GDP among Countries

It is common to use GDP as a measure of economic welfare or standard of living in a nation. When comparing the GDP of different nations for this purpose, two issues immediately arise. First, the GDP of a country is measured in its own currency: the United States uses the U.S. dollar; Canada, the Canadian dollar; most countries of Western Europe, the euro; Japan, the yen; Mexico, the peso; and so on. Thus, comparing GDP between two countries requires converting to a common currency. A second issue is that countries have very different numbers of people. For instance, the United States has a much larger economy than Mexico or Canada, but it also has roughly three times as many people as Mexico and nine times as many people as Canada. So, if we are trying to compare standards of living across countries, we need to divide GDP by population.

Converting Currencies with Exchange Rates

To compare the GDP of countries with different currencies, it is necessary to convert to a “common denominator” using an exchange rate, which is the value of one currency in terms of another currency. Exchange rates are expressed either as the units of country A’s currency that needs to be traded for a single unit of country B’s currency (for example, Japanese yen per British pound), or as the inverse (for example, British pounds per Japanese yen). Two types of exchange rates can be used for this purpose, market exchange rates and purchasing power parity (PPP) equivalent exchange rates. Market exchange rates vary on a day-to-day basis depending on supply and demand in foreign exchange markets. PPP-equivalent exchange rates provide a longer run measure of the exchange rate. For this reason, PPP-equivalent exchange rates are typically used for cross-country comparisons of GDP.

Converting GDP to a Common Currency

Using the exchange rate to convert GDP from one currency to another is straightforward. Say that the task is to compare Brazil’s GDP in 2012 of 4,403 billion reals with the U.S. GDP of $16,245 trillion for the same year.

Step 1. Determine the exchange rate for the specified year. In 2012, the exchange rate was 1.869 reals = $1. (These numbers are realistic, but rounded off to simplify the calculations.)

Step 2. Convert Brazil’s GDP into U.S. dollars:

Brazil's GDP in $ U.S. = Brazil's GDP in reals

Exchange rate (reals/$ U.S.)

= 4,403 billion reals

1.869 reals per $ U.S.

= $2,355.8 billion

Step 3. Compare this value to the GDP in the United States in the same year. The U.S. GDP was $16,245 in 2012 which is nearly seven times that of GDP in Brazil in 2012.

Step 4. View Table 2 which shows the size of and variety of GDPs of different countries in 2012, all expressed in U.S. dollars. Each is calculated using the process explained above.

Country	GDP in Billions of Domestic Currency	Domestic Currency/U.S. Dollars(PPP Equivalent)	GDP (in billions of U.S. dollars)
Brazil	4,403	reals	1.869	2,356
Canada	1,818	dollars	1.221	1,488
China	51,932	yuan	4.186	12,406
Egypt	1,542	pounds	2.856	540
Germany	2,644	euros	0.827	3,197
India	97,514	rupees	20.817	4,684
Japan	475,868	yen	102.826	4,628
Mexico	15,502	pesos	8.813	1,759
South Korea	1,302,128	won	806.81	1,614
United Kingdom	1,539	pounds	0.659	2,336
United States	16,245	dollars	1.000	16,245

Comparing GDPs Across Countries, 2012

(Source: http://www.imf.org/external/pubs/ft/weo/2013/01/weodata/index.aspx)

GDP Per Capita

The U.S. economy has the largest GDP in the world, by a considerable amount. The United States is also a populous country; in fact, it is the third largest country by population in the world, although well behind China and India. So is the U.S. economy larger than other countries just because the United States has more people than most other countries, or because the U.S. economy is actually larger on a per-person basis? This question can be answered by calculating a country’s GDP per capita; that is, the GDP divided by the population.

GDP per capita = GDP/population

The second column of Table 2 lists the GDP of the same selection of countries that appear in Tracking Real GDP over Time and Table 2, showing their GDP as converted into U.S. dollars (which is the same as the last column of the previous table). The third column gives the population for each country. The fourth column lists the GDP per capita. GDP per capita is obtained in two steps: First, by dividing column two (GDP, in billions of dollars) by 1000 so it has the same units as column three (Population, in millions). Then dividing the result (GDP in millions of dollars) by column three (Population, in millions).

Country	GDP (in billions of U.S. dollars)	Population (in millions)	Per Capita GDP (in U.S. dollars)
Brazil	2,356	198.36	11,875
Canada	1,488	34.83	42,734
China	12,406	1354.04	9,162
Egypt	540	82.50	6,545
Germany	3,197	81.90	39,028
India	4,684	1223.17	3,830
Japan	4,628	127.61	36,266
Mexico	1,614	50.01	32,272
South Korea	1,759	114.87	15,312
United Kingdom	2,336	63.24	36,941
United States	16,245	314.18	51,706

GDP Per Capita, 2012

(Source: http://www.imf.org/external/pubs/ft/weo/2013/01/weodata/index.aspx)

Notice that the ranking by GDP is different from the ranking by GDP per capita. India has a somewhat larger GDP than Germany, but on a per capita basis, Germany has more than 10 times India’s standard of living. Will China soon have a better standard of living than the U.S.?

Since GDP is measured in a country’s currency, in order to compare different countries’ GDPs, we need to convert them to a common currency. One way to do that is with the exchange rate, which is the price of one country’s currency in terms of another. Once GDPs are expressed in a common currency, we can compare each country’s GDP per capita by dividing GDP by population. Countries with large populations often have large GDPs, but GDP alone can be a misleading indicator of the wealth of a nation. A better measure is GDP per capita.

Answer the self check questions below to monitor your understanding of the concepts in this section.

Self Check Questions

1. Define "real GDP per capita".
2. How is real GDP calculated?
3. How can GDP and population influence output?
4. Define the term "standard of living".
5. Define the term "tax base".
6. Define the term "renewable resources".
7. What is "capital-to-labor ratio"?
8. Define the term "labor productivity".