Economic growth is the sustained expansion of production possibilities measured as the increase in real GDP over a given period. The economic growth rate is the annual percentage change of real GDP. It tells us how rapidly the total economy is expanding.

The standard of living depends on real GDP per person. Real GDP per person is real GDP divided by the population. It grows only if real GDP grows faster than the population grows.

The Production Function and Potential GDP

Y = A F(L, K)

The quantity of real GDP supplied, Y, depends on the quantity of labor, L, the quantity of capital, K, and the state of technology, A (total factor productivity).

This equation shows that output depends on inputs and the level of technology.

• More inputs mean more output. That is, the marginal product of labor (the increase in output generated by increased labor) and the marginal production of capital (the increase in output generated by increased capital) are both positive.
• The higher the level of technology, the more output is produced for a given level of inputs.

The law of diminishing returns: As the quantity of one input increases with the quantities of all other inputs remaining the same, output increases but by ever smaller increments. As capital per hour of labor rises, output rises (the marginal product of capital is positive) but output rises less at high levels of capital than at low levels. This is the key explanation of why the economy reaches a steady state rather than growing endlessly.

Convergence is the process of one economy catching up with another economy. According to the neoclassical growth theory, countries with a low level of capital would have a higher marginal product of capital because of diminishing returns and hence attract more investment and grow faster.

Growth in Y = Growth in technology + W_L (growth in labor) + W_C (growth in capital)

where W_L and W_C = 1 - W_L are the shares of labor and capital in GDP.

Sources of Economic Growth

There are five important sources of growth for an economy:

• Labor supply is the quantity of the work force. It is determined by population growth, the labor force participation rate, and net immigration.
• Human capital measures the quality of the labor force. Human capital acquired through education, on-the-job training, and learning-by-doing is the most fundamental source of economic growth. It is the source of increased labor productivity and technological advance.
• Physical capital results from saving and investment decisions. The accumulation of new capital increases capital per worker and labor productivity.
• Technology. Technological change - the discovery and the application of new technologies and new goods - has contributed immensely to increasing labor productivity. It is the main factor affecting economic growth in developed countries.
• Natural resources account for some of the differences in growth among countries.

Measures of Sustainable Growth

Labor productivity is the quantity of real GDP produced by an hour of labor. The growth of labor productivity depends on physical capital growth, human capital growth, and technology advances.

Potential GDP = Aggregate hours worked x Labor productivity

Potential growth rate = Long-term growth rate of labor force + Long-term labor productivity growth rate

Practice Question 1

Sustainable growth is measured by the rate of increase in an economy's ______.

A. potential GDP
B. real GDP
C. nominal GDP

Correct Answer: A

This is the economy's productive capacity.

Practice Question 2

Economic growth means ______.

I. a higher standard of living
II. physical and human capital
III. technology gains
IV. availability of natural resources

Correct Answer: I

Economic growth means more income and a higher standard of living. The other responses represent sources of economic growth.

Practice Question 3

Sources of ongoing economic growth include all of the following activities except ______.

A. investment in new capital
B. current consumption
C. discovery of new technologies
D. investment in human capital

Correct Answer: B

Practice Question 4

The law of diminishing returns states that if a given number of hours of labor use more capital (with the same technology), then the ______ as the amount of capital increases.

I. total output that results from the additional capital gets larger
II. additional output that results from the additional capital gets smaller
III. additional output that results from the additional capital gets larger

Correct Answer: I and II

Practice Question 5

The only way to sustain growth in potential GDP per capita is through ______.

A. population growth
B. capital deepening investment
C. technological change

Correct Answer: C

This is because of diminishing returns to capital. The growth-accounting equation also shows that improvements in technology are more important than capital in raising an economy's standard of living.

Practice Question 6

An economics student has estimated the following growth-accounting equation from historical data based on the Solow growth model:

Growth in potential GDP = 2.2 + 0.42 x growth in labor + 0.38 x growth in capital

What's wrong with the equation?

Correct Answer: 042 + 0.38 ≠ 1

The labor share and the capital share should add up to 1.

Practice Question 7

The law of diminishing returns states that if a given number of hours of labor use more capital (with the same technology), then the ______

A. additional output that results from the additional capital gets larger as the amount of capital increases.
B. additional output that results from the additional capital gets smaller as the amount of capital increases.
C. total output that results from the additional capital gets smaller as the amount of capital increases.

Correct Answer: B

Practice Question 8

True or False? Faster growth is always better for an economy.

Correct Answer: False

There are costs associated with excess growth, such as inflation.

Practice Question 9

Which one describes the quality of the work force?

A. Average hours worked
B. Labor force participation rate
C. Human capital

Correct Answer: C

It is the accumulated knowledge and skills that workers acquire from education, training, or life experience.

Practice Question 10

Suggestions for achieving faster long-run economic growth include the following except for ______.

A. stimulating research and development
B. stimulating consumption
C. improving the quality of education

Correct Answer: B

A: technology improvement. C: human capital growth.

Practice Question 11

An economics student has estimated the following growth-accounting equation from historical data based on the Solow growth model:

Growth in potential GDP = 2.2 + 0.7 x growth in labor + 0.3 x growth in capital

What is the growth rate of total factor productivity?

A. 2.2
B. 3.2
C. It cannot be determined by the above equation.

Correct Answer: A

The intercept of the Solow growth accounting equation is the growth rate of total factor productivity. It reflects an increase in output for given inputs.

Practice Question 12

What causes a proportional upward shift in the entire production function? An increase in ______.

A. capital-to-labor ratio
B. total factor productivity
C. marginal productivity of capital

Correct Answer: B

A higher output can be produced per worker for a given level of capital per worker.