What Drives Economic Growth?

Economic growth is a fundamental aspect of a country’s prosperity and well-being.

It allows for improved living standards, creates job opportunities, and fosters innovation.

For traders and investors, economic growth – particularly changes in its discounted expectations – is one of the main drivers of asset prices at the broad asset class level (in addition to changes in discounted inflation, discount rates, and risk premiums).

However, understanding what drives economic growth is a complex issue involving numerous factors.

Let’s look into the primary drivers that contribute to a nation’s economic growth.

Key Takeaways – What Drives Economic Growth?

• Economic growth is driven by productivity growth and the growth in work hours (what real GDP is), which are influenced by factors such as technological advancements, education, population growth, and labor force participation rates.
• Government policies play an important role in driving economic growth by promoting competition, innovation, and investment-friendly environments.
• Pursuing economic growth should consider the importance of sustainable and inclusive growth to address income inequality and environmental concerns.

Productivity Growth

Productivity growth is one of the key drivers of economic growth.

It is defined as the increase in the amount of goods and services produced with a given amount of inputs, like labor, capital, or materials.

In simple terms, when a country can produce more with the same or fewer resources, its productivity rises.

This can be a result of technological advancements, improved skills, and better organization and management.

Technological innovation is a primary driver of productivity growth. New technologies enable workers to produce more output with the same amount of labor and capital.

Investments in human capital, such as education and training, can also boost productivity. When workers have better skills and knowledge, they can perform their tasks more efficiently and effectively.

Improvements in organization and management can also lead to increased productivity.

Efficient allocation of resources, streamlined processes, and effective management strategies can all contribute to producing more with the same inputs.

Ways to Grow Productivity and the Macroeconomic Level

• Investment in Infrastructure: Improved roads, ports, and tech infrastructure.
• Education Spending: Equip workforce with relevant skills.
• R&D Tax Incentives: Encourage technological innovation.
• Trade Liberalization: Access to efficient tech and best practices.
• Labor Market Reforms: Enhance labor mobility and flexibility.
• Regulatory Streamlining: Reduce business process bottlenecks.
• Tax Policies: Incentives for productive capital investments.
• Monetary Policies: Stable prices to support long-term planning.
• Encourage Entrepreneurship: Policies to support startups and SMEs.
• Foreign Direct Investment (FDI): Access to best global practices.
• Sustainable Development: Long-term environmental and economic balance.

Ways to Grow Productivity and the Microeconomic Level

• Technology Adoption: Implement modern tools and software.
• Employee Training: Regular skills development sessions.
• Efficient Management: Adopt lean processes and eliminate waste.
• Incentives: Offer rewards for high performers.
• Flexible Work Options: Allow remote work and flexible hours.
• Feedback Loop: Encourage open communication for improvement.
• Healthy Work Environment: Ergonomic setups and mental well-being initiatives.
• Task Automation: Use bots and scripts for repetitive tasks.
• Continuous Learning: Promote a culture of ongoing education.
• Goal Setting: Define clear objectives and key results.
• Team Collaboration: Foster team building and collaborative efforts.

Growth in Work Hours

The growth in the number of work hours is another critical driver of economic growth.

Growth in the Workforce

It’s largely a function of the growth in the workforce, which depends on factors like population growth and labor force participation rates.

Population growth directly influences the size of the workforce. In economies where the population is growing, the potential workforce also grows.

So, you might see policies directly related to incentivizing higher birth rates.

For example, in February 2019, Hungary’s prime minister Viktor Orbán stated that women who birth four or more children will never have to pay income tax again.

The idea is that the lost tax revenue in the present will be an investment to get more tax revenue in the future by getting more future workers going forward.

This can increase the total number of work hours and, hence, the total output produced.

Population size and growth can make a big difference on the overall size of an economy.

In China, for instance, they have four times the population of the US, so if they can just get their productivity rates to half the size they’ll be twice as big.

Labor Force Participation Rate

Labor force participation rate, the percentage of the working-age population either employed or actively looking for work, is another determinant.

Higher participation rates indicate more people in the workforce, contributing to the total output.

Quality of Work

An important factor related to work hours is the quality of work.

Not all work hours are equal, and high-quality, productive work can contribute more to economic growth than a large number of low-quality work hours.

Role of Government Policies

Government policies also play a significant role in driving economic growth.

Policies that promote competition, encourage innovation, and facilitate investment can all contribute to growth.

Policies that promote competition can drive economic growth by encouraging efficiency and innovation. Competitive markets force companies to improve their products and services, increase efficiency, and reduce costs.

Governments can also drive economic growth by fostering a favorable environment for innovation.

This can involve policies that protect intellectual property rights, provide research and development subsidies, and create a favorable regulatory environment for new business models and technologies.

Investment-friendly policies can facilitate economic growth by attracting both domestic and foreign capital. These policies can include tax incentives, streamlined regulatory processes, and protections for investors.

Example of Types of Macroeconomic Policies to Spur Economic Growth

• Monetary Policies: Lowering interest rates to boost investment.
• Fiscal Policies: Increasing government expenditure on infrastructure.
• Tax Reforms: Reducing corporate tax rates to spur business activity.
• Trade Policies: Reducing tariffs to promote imports and exports.
• Labor Market Reforms: Encouraging skills training and reducing employment restrictions.
• Regulatory Environment: Streamlining business regulations to encourage entrepreneurship.
• Foreign Direct Investment (FDI): Liberalizing FDI policies to attract overseas capital.

FAQs – What Drives Economic Growth?

What is the basic definition of economic growth?

Economic growth refers to an increase in a country’s production or income per capita, which implies a rise in the overall living standards of its citizens.

This growth is often measured in real terms, which means it accounts for inflation to get at living standards rather than just nominal changes.

It’s a result of increased productivity and the growth of the workforce (which is the total number of work hours).

How does productivity growth drive economic growth?

Productivity growth is a critical driver of economic growth.

It refers to increases in the output (goods and services) that can be produced per unit of input (such as labor hours, machines, and materials).

If a nation’s businesses can produce more goods and services using the same amount of resources, they have increased their productivity.

This increased productivity leads to higher incomes and improved living standards, thereby driving economic growth.

How does the growth of the workforce influence economic growth?

The growth of the workforce—or more specifically, an increase in the total number of work hours – significantly contributes to economic growth.

When more people are employed or existing workers work longer hours, there’s a larger total labor input, which allows for the production of more goods and services.

This expanded output contributes to economic growth.

However, workforce growth isn’t as potent a driver of growth as productivity, since there are natural limits to the number of hours a worker can work and how many people can participate in the workforce.

What is the role of technological innovation in driving economic growth?

Technological innovation plays an important role in driving economic growth by boosting productivity.

Innovations can lead to new ways of producing goods or providing services, making processes more efficient, reducing waste, or creating entirely new products or markets.

By increasing productivity, technology enables the economy to produce more with the same amount of resources, thereby driving economic growth.

How do government policies influence economic growth?

Government policies can significantly impact economic growth by affecting productivity and workforce growth.

Policies that support education, training, and research can enhance productivity by improving workers’ skills and encouraging technological innovation.

Likewise, policies regarding immigration, retirement age, and labor market regulation can influence the size and effectiveness of the workforce.

However, the government’s role and the effectiveness of these policies can vary greatly between different countries and economic contexts.

How does investment in infrastructure impact economic growth?

Investment in infrastructure, such as roads, bridges, airports, broadband networks, and power grids can also drive economic growth by increasing both productivity and workforce growth.

Infrastructure improves productivity by reducing the cost and time of transporting goods and people or transmitting information.

It can also encourage workforce growth by making it easier for people to access jobs or work more effectively.

What role does economic stability play in economic growth?

Economic stability is an essential factor for sustained economic growth.

When an economy is stable, with low inflation and unemployment, businesses and consumers have more confidence to invest, spend, and take risks, all of which can drive growth.

In contrast, periods of instability, such as economic recessions or high inflation, can reduce spending and investment, thereby slowing economic growth.

How does international trade contribute to economic growth?

International trade can contribute to economic growth by expanding markets and promoting productivity.

When countries trade, businesses can sell to larger markets, which encourages production.

Additionally, trade can lead to increased competition and the transfer of technology and ideas, which can boost productivity.

However, the benefits of international trade can be uneven, and some sectors or workers within an economy may face challenges due to international competition.

In the US and some other countries, the loss of jobs due to offshoring led to more political populism.

How does population growth impact economic growth?

Population growth can impact economic growth in several ways.

More people can provide a larger labor force, which can lead to more goods and services being produced.

However, population growth also means more people to feed, house, and educate.

If an economy can’t keep up with its population growth – in terms of jobs, infrastructure, and social services – it may not translate into economic growth.

Additionally, rapid population growth can strain resources and the environment, which could undermine long-term growth.

What are the limitations or potential pitfalls of pursuing economic growth?

While economic growth is generally associated with improvements in living standards, it also can bring stresses in other ways.

For instance, economic growth may be accompanied by income/wealth inequality, where the benefits of growth accrue disproportionately to the wealthy.

Furthermore, economic growth can lead to environmental degradation if it involves harmful practices or overuse of natural resources.

Therefore, many economists argue for the pursuit of sustainable and inclusive growth, which aims to balance economic advancement with social equity and environmental sustainability.

Chinese policymakers tend to be particularly sensitive to wealth inequality, as many rulers in previous centuries saw revolutions and rebellions when the fruits of the country’s productivity and opportunities afforded weren’t distributed in a broad-based way.

Conclusion

Economic growth is driven by a multitude of factors, including productivity growth and the growth in work hours.

Technological advancements, improvements in human capital, and better organization can all drive productivity growth.

The growth in work hours, influenced by population growth and labor force participation rates, is another key driver.

Government policies that promote competition, encourage innovation, and facilitate investment can also contribute significantly to economic growth.

Understanding these drivers can help policymakers and businesses create strategies that foster sustainable, broad-based growth.