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What is Economic Growth? - Definition, Theory & Impact

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  • 0:00 Definition of Economic Growth
  • 0:44 Classical Theory
  • 1:31 Neo-Classical Theory
  • 3:11 New Growth Theory
  • 4:04 Lesson Summary
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Lesson Transcript
Instructor: Kallie Wells
How do we measure and explain economic growth? This lesson will go through the various theories of economic growth which all try to explain how a country continues to increase production.

Definition

Economic growth is the increase in the goods and services produced by an economy, typically a nation, over a long period of time. It is measured as percentage increase in real gross domestic product (GDP) which is gross domestic product (GDP) adjusted for inflation. GDP is the market value of all final goods and services produced in an economy or nation.

So how does a nation or economy continually increase the GDP such that the economic growth trends upward? There are three main types of economic growth theories over time that have all attempted to answer that exact question. The Classical, Neo-Classical, and Modern Day theories will each be described.

Classical Theory

The classical theory of economic growth was a combination of economic work done by Adam Smith, David Ricardo, and Robert Malthus in the eighteenth and nineteenth centuries. The theory states that every economy has a steady state GDP and any deviation off of that steady state is temporary and will eventually return. This is based on the concept that when there is a growth in GDP, population will increase. The increase in population thus has an adverse effect on GDP due to the higher demand on limited resources from a larger population. The GDP will eventually lower back to the steady state. When GDP deviates below the steady state, population will decrease and thus lower demand on the resources. In turn, the GDP will rise back to its steady state.

Thomas Malthus - Classical Growth Theorist
Thomas Malthus - Classical Growth Theorist

Neo-Classical Theory

Next, we have Neo-Classical theory. Two economists, T.W. Swan and Robert Solow, made important contributions to economic growth theory in developing what is now known as the Solow-Swan growth model. The theory focuses on three factors that impact economic growth: labor, capital, and technology, or more specifically, technological advances. The output per worker (growth per unit of labor) increases with the output per capita (growth per unit of capital) but at a decreasing rate. This is referred to as diminishing marginal returns. Therefore, there will become a point at which labor and capital can be set to reach an equilibrium state.

Since a nation can theoretically determine the amount of labor and capital necessary to remain at that steady point, it is technological advances that really impact the economic growth. The theory states that economic growth will not take place unless there are technological advances, and those advances happen by chance. Once an advance has been made, then labor and capital should be adjusted accordingly. It also suggests that if all nations have access to the same technology, then the standard of living will all become equal.

There were two major concerns with this era of theories. One is the conclusion that continuous economic growth can only occur with technological advances, which happen by chance and therefore cannot be modeled. Secondly, it relies on diminishing marginal returns of capital and labor. However, there is no empirical or real-life evidence to support this claim. Therefore the model is known for identifying technology as a factor in growth but fails to ever substantially explain how.

Robert Solow - Neoclassical Growth Theorist
Robert Solow - Neoclassical Growth Theorist

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