Economic Growth and Drivers of Economic growth

Why is economic growth important and what propels it?

A country’s growth and level of national income, measured by real gross domestic product (GDP), is used as an indicator of development. A higher GDP is correlated with low crime rates, higher life expectancy, and general good health, higher education levels, less poverty, low levels of conflicts and a higher public service delivery, among others. Improvements in the level of GDP become central to improving the well-being of the society. Before going into the drivers of GDP, let’s briefly examine its components first.

National income captured by GDP has four components which are personal consumption, investment, government spending and net exports (exports minus imports). Each of these components plays a crucial role in determining the growth in GDP and subsequently the economy. An increase in autonomous consumption stimulates the economy in a ripple manner that causes income to increase by a significantly greater proportion than the initial increase in consumption. Investment increases the country’s productive capacity leading to an increase in income via production. Government consumption/purchases increases GDP through the multiplier effect where a smaller proportion of spending results in significant increases in income. For simplicity, we just assume that the government is forward looking and thus engages in productive spending which positively contributes to economic growth. In later posts, we will relax this assumption and discuss the implications to national income in the instance when the government lacks that foresight.  Lastly, exports inject income into the economy while imports act as a leakage of income. As a country grows, it generally spends more on investment and at later stages it re-balances by leaning heavily on private consumption.

Another important avenue to increasing national income is through increasing productivity.  Productivity – generated through what’s called an aggregate production function is the process whereby an economy as a whole turns economic inputs into output measured as GDP. The components of a production function are human capital, workforce, physical capital, and technology. Human capital the accumulated skills and education of workers and increases output per worker. Workforce is the total number of people in a country or region who are physically able to do a job and are available for work and the higher the number the higher is output. Physical capital consists of man-made goods such as machinery, computers, and other equipment that are needed for the production of goods and services. A higher investment in physical capital increases labour productivity. Lastly, technical knowledge refers to society’s understanding about how the world works, hence, how goods can be produced in the best way possible by combining all the production inputs. Constantly, acquiring new technology increases the ability to produce more output per each resource a country has.

Another major thing that also influences economic growth in developing countries is the quality of governance as measured by the following six components: (1) Government effectiveness - measures the perceptions of the quality of public services, civil service and the extent of their independence from political pressures, the quality of policy formulation and implementation, and the credibility of the government’s commitment to such policy strategies. , regulatory quality, voice and accountability, political stability, control of corruption, and the rule of law; (2) Regulatory quality – captures the perceptions of the ability of the government to formulate and implement sound policies and regulations to promote private sector development; (3) Rule of law – encompasses the extent to which economic agents abide by societal rules and trust the government including contract enforcement, property rights, police, judicial system and the likelihood of crime and violence; (4) Voice and accountability – captures the views and extent to which economic agents partake in electing their own government, are free to express themselves, and have free access to the media; (5) Political stability – measures the degree to which a country is susceptible to the likelihood of politically-motivated violence  including terrorism; and (6) Control of corruption – captures the perceptions of the extent to which public power is exercised for private gain including petty and larger forms of corruption. It’s important to note that the failure of any one or all of the governance indicators will contribute to market failure or inefficiency which will inevitably have a negative impact on the country’s economic growth.