Economic Growth

What is economic growth?

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

As defined, GDP is a measure of production, and the level of production is an important indicator that shows how much a country can afford to consume both individually and collectively. Therefore, it affects the level of employment and influences the welfare of a community.

Real GDP vs Nominal GDP

Economic growth can be measured in ‘normal’ and ‘real’ terms.

• Normal GDP: the dollar value of the goods and services produced in a time period.

• Real GDP: only captures the volume of what was produced.

Economists normally talk about real economic growth, which takes away the effect of changing prices because it reflects how much a country produces at a given time, compared with other points in time.

How is GDP measured?

Economic growth is difficult to measure accurately. That’s because when counting services or intangible products, things get a little muddled. As a result, economists have traditionally used Gross Domestic Product (GDP) as an indicator of an economy’s growth or recession. There are three ways of measuring GDP, each of which should give the same answer.

These methods are:

The Output Method

Measure GDP as the value of:

• Output

• (-) Inputs used up in producing these outputs

• (+) All taxes on products such as VAT

• (-) All subsidies on products such as renewable energy subsidies

The Income Method

Measure GDP by adding together:

• Gross operating surplus of companies and the self-employed

• (+) Wages of employees, rents, interests

• (+) All taxes on products such as VAT

• (-) All subsidies on products such as renewable energy subsidies

The Expenditure Method

Measure how much is spent on goods and services:

• Consumer spending by individuals

• (+) Net expenditure by central and local government

• (+) All capital spending such as buildings and machines

• (+) Net exports (exports – imports)

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Comparing GDP among countries

Although Gross Domestic Product (GDP) is often used to measure the economic welfare or standard of living of a nation, two key challenges arise when comparing GDP among countries for this purpose.

• First, each country will measure GDP in its own currency – the United States uses the U.S. dollar, Canada uses the Canadian dollar, Japan uses the yen and so on. Therefore, in order to compare the GDP between the two nations, it is required to be converted into a common currency. 

• The second issue is related to population size. For example, while the U.S. economy is much larger than those of Mexico and Canada, it also has nearly three times the population of Mexico and about nine times the population of Canada. Thus, to accurately compare the living standards between countries, the entire GDP needs to be divided by population (GDP per capita). 

Converting Currencies with Exchange Rates

With the first issue, it is necessary to convert the GDP of countries with different currencies using an exchange rate, which is the value of one currency in terms of another currency (e.g. Japanese yen per British pound).

Two types of exchange rates:

• Market exchange rates fluctuate on a day-to-day basis depending on the demand and supply in foreign exchange markets. Since they are volatile and can change quickly, they may not be the most stable option for comparing GDP over time.

• Purchasing power parity (PPP) equivalent exchange rates aim to equalize the purchasing power of different currencies by considering what the same amount of money can buy in each country (e.g. if a loaf of bread costs $2 in the U.S. and the equivalent of $2 in Japan, the exchange rate between the U.S. dollar and the Japanese yen would reflect that purchasing power). By doing so, PPP helps provide a more accurate reflection of the real economic output and living standards across nations.

GDP Per Capita

When a country’s economy is larger than another country’s, the question is whether it has more people than other countries or because its economy is actually larger on a per-person basis. The answer lies in a calculation of a country’s GDP per capita; that is, the GDP divided by the population.

GDP per capita = GDP/Population

Table of GDP per capita of selected countries in 2021. Source: (https://www.imf.org/en/Publications/WEO/weo-database/2022/April/)

As shown from the above table, China ranks as the second largest GDP of the countries with $17 trillion compared to the United States’ $23 trillion. However, in per capita terms, its GDP is less than 1/5 that of the United States ($12,358 compared to $69,231) due to China’s much larger population.

What GDP does not reveal

It is also vital to understand what GDP cannot tell us. GDP is not a measure of the overall standard of living or well-being of a country. Indeed, the total welfare depends on many non-economic events including epidemics, droughts, floods, the state of the environment, levels of crime, freedom or security, thus, changes in GDP do not necessarily correspond to changes in the general well-being.

For instance, an increase in output may come at the cost of environmental damage or other external costs such as pollution, health risks or noise. Or it might involve reducing leisure time or the depletion of non-renewable natural resources. Similarly, GDP does not tell us anything about how evenly national income is split across the population.

References

Brown, T & Foreman, C 2022, UH Macroeconomics 2022, OpenStax, Houston, TX, pp. 199-259.

McKinsey & Company 2022, What is economic growth?, McKinsey & Company, available at <https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-economic-growth>.

Reserve Bank of Australia n.d., Economic Growth, Reserve Bank of Australia, available at <https://www.rba.gov.au/education/resources/explainers/economic-growth.html>.

Tim, C n.d., Gross Domestic Product: An Economy’s All, International Monetary Fund, available at <https://www.imf.org/en/Publications/fandd/issues/Series/Back-to-Basics/gross-domestic-product-GDP>.