Why long-run growth matters
Over decades, the main driver of rising living standards is not the business cycle but the growth rate of output per person. Because growth compounds, small differences in the annual rate lead to very different outcomes.
Worked example: compounding
Suppose two countries each start with real GDP per person of 100.
- Country A grows at 2% a year. After 35 years, 100 × 1.02^35 ≈ 200, so it doubles (the rule of 70 gives 70 ÷ 2 = 35 years).
- Country B grows at 4% a year. After 35 years, 100 × 1.04^35 ≈ 395, nearly four times the starting level.
Two extra percentage points a year leave country B almost twice as rich as A after one generation and a half.
Productivity
Labour productivity is output per hour of work. If a factory produces 600 units in 40 hours, productivity is 600 ÷ 40 = 15 units per hour. Output growth can be split approximately into growth of hours worked and growth of productivity. If output rises 6% while hours rise 2%, productivity rises about 4% (1.06 ÷ 1.02 ≈ 1.039). Over the long run, almost all growth in income per person comes from productivity.
Sources of productivity growth
- Physical capital deepening: more and better machines, buildings and infrastructure per worker. Investing means giving up some consumption today for more output later.
- Human capital: the skills, health and knowledge of workers, built through education, training and experience.
- Technology: better ways to combine inputs. Ideas are non-rival: once discovered, many firms can use them, which is why innovation can drive growth beyond what adding more inputs would do.
- Institutions: secure property rights, reliable courts, stable money and open markets encourage saving, investment and innovation. Economists debate how much weight each source deserves.
Diminishing returns and catch-up
Adding more capital to a fixed number of workers gives smaller and smaller gains, a form of diminishing returns. That is one reason economists expect poorer countries, which have little capital per worker, to grow faster than richer ones if other conditions are similar. This idea is called convergence or catch-up growth. In the real world, convergence is far from automatic: countries with weak institutions or unstable politics often fail to catch up, while some have grown very fast by adopting existing technology and raising investment.
Saving and investment
An economy can build capital only by not consuming all of its output. Domestic saving, together with borrowing from abroad, funds investment. In the loanable funds picture, saving supplies funds and investment demands them, and the interest rate is the price that balances the two. Policies that raise saving or make investment more attractive can raise growth, though there are trade-offs with current consumption.
Limits and costs
Growth can raise pollution and use up resources unless technology and policy adjust. GDP growth also tells us nothing about how gains are shared. Even so, rising productivity is the basis for better health, education and shorter working hours.