External environment - Economic indicators

Theory 4 - Economic growth - what is it and what contributes to it?

Economies tend to grow in cycles - consistently high growth is rare. The cycle of growth is called the business cycle or the trade cycle and is shown in the diagram below.

At the peak of the cycle (boom period), growth is high, unemployment low but inflation may be starting to rise as high growth in demand starts to cause demand-pull inflation. The emergence of inflation may cause deflationary policies to be put in place and growth may start to fall (the downturn). It may even slow down to the extent that there is a recession. This is defined as two successive quarters of negative growth.

Measuring growth

Economic growth is growth in the level of national income. There are various measures of national income, but the most commonly used one is gross domestic product (GDP). We measure growth as the percentage change in GDP. However, it is very important that we only take the percentage change in real GDP. This means the change in GDP after inflation has been taken into account.

Causes of growth

Governments are obviously keen to encourage economic growth and to do that they need to be sure about the main contributory factors. The main sources of growth are:

• Natural resources - if an economy has a plentiful supply of natural resources it may help it to expand. However, natural resources on their own are not enough. There also have to be the skilled people to exploit the opportunities. This means that education and training become critical factors contributing to growth.
• Capital - more capital generally means more production, and more production means more growth. To get capital, countries have to invest and so the level of investment may be a big determinant of future growth. The quality of the capital is important as well. It's no good investing in out of date equipment!
• Rate of savings - to have more tomorrow you often have to have less today (jam tomorrow!). This is true with savings as well. To provide funds for investment there needs to be a good level of savings. This should in turn mean more growth in the future.
• Technological progress - this is perhaps the most widely accepted (and easiest to understand) source of economic growth. This is because technology makes it possible to produce more from the same quantity of resources (or factors of production). This boosts the potential level of output of the economy. The pace of technological change will depend on:
  • the scientific skills of the country
  • the quality of education
  • the amount of GDP devoted to research and development