Long-Run Economic Growth

Long-Run Economic Growth Is the Key to Rising Living Standards

One of the primary goals of most national governments is to achieve sustainable growth of real income per person (hereafter economic growth), in the belief that it can help raise the economic wellbeing of the population as a whole.

Long-run economic growth is the process by which rising productivity increases the average standard of living.

Most people in Australia, Western Europe, the United States, Japan and other advanced countries expect that over time their standard of living will improve.

They expect that year after year firms will introduce new and improved products and new prescription drugs, better surgical techniques will overcome more diseases, and their ability to afford these goods and services will increase.

For most people these are reasonable expectations.

When the states of Australia formed a federation in 1901, Australia was already enjoying one of the highest standards of living in the world.

Yet in that year only 3 percent of homes had electricity and almost no homes had indoor flush toilets. Diseases such as smallpox, typhus, dysentery and cholera were still menacing the health of Australians.

In 1901 there were, of course, no televisions, radios, computers, air conditioners or refrigerators. Most homes were heated in winter by burning wood or coal, which contributed to pollution. There were no modern appliances, and most women worked inside the home at least 80 hours per week. The typical Australian homemaker in 1901 baked half a ton of bread per year!

The process of long-run economic growth brought the typical Australian from the standard of living of 1901 to the standard of living of today.

The best measure of the standard of living is real GDP per person, which is usually referred to as real GDP per capita.

So we measure long-run economic growth by increases in real GDP per capita.

We use real GDP rather than nominal GDP to adjust for changes in the price level over time.

Figure I shows real GDP per capita in Australia from 1901 to 2007 (Actually the author's original Figure shows the data from 1901 to 2013 but for non-availability of the very Figure, we use this particular one).

real GDP per capita in Australia from 1901 to 2007 Figure I. Real GDP per capita in Australia from 1901 to 2007 | Source: Slideplayer Opens in new window

From the figure we can see that although real GDP per capita fluctuates because of the business cycle, over the long run the trend is strongly upward, notably from the 1960s onward.

The values in Figure I are measured in prices of the financial year 1966/67, so they represent constant amounts of purchasing power.

In 1901 real GDP per capita was about $1150. Over a century later, in 2013, it had risen to about $6222, which means that the average Australian in 2013 could purchase more than five times as many goods and services as the average Australian in 1901.

Large as it is, this increase in real GDP per capita actually understates the true increase in the standard of living of Australians in 2007 compared with 1901.

Many of today’s goods and services were not available in 1901.

For example, if you lived in 1901 and became ill with a serious infection, you would have been unable to purchase antibiotics to treat your illness no matter how high your income. You might have died from an illness for which even a very poor person in today’s society could receive effective medical treatment.

Of course, the quantity of goods and services that a person can buy is not a perfect measure of how happy or contented that person may be.

As mentioned in the previous post Opens in new window, the level of pollution, the level of crime, the amount of leisure time, spiritual wellbeing and many other factors ignored in calculating GDP contribute to a person’s happiness.

Nevertheless, economists rely heavily on comparisons of real GDP per capita because it is the best means of comparing the performance of one economy over time or the performance of different economies at any particular time.

Calculating Growth Rates and the Rule of 70

The economic growth rate is equal to the percentage change in real GDP from one year to the next.

For example, real GDP equaled approximately $1.452 trillion in 2012 and rose to $1.493 trillion in 2013 (for financial years ending 30 June).

We calculate the economic growth rate between 2012 and 2013 as:

calculating formula for economic growth rate
For longer periods of time we can use the average annual economic growth rate.

For example, real GDP in Australia was approximately $236 billion in 1960 and $1493 billion in 2013.

To find the average annual growth rate during this 53-year period we calculate the growth rate that would result in $236 billion growing to $1493 billion over 53 years.

(This involves a lot of calculating so a compounding calculator is used to do this). In this case the growth rate is 3.7 percent.

That is, if $236 billion grows at an average rate of 3.54 percent per year, after 53 years it will have grown to $1493 billion.

For shorter periods of time, we can calculate average economic growth rates in real GDP by averaging the growth rate for each year.

For example, real GDP in Australia grew by approximately 2.4 percent in 2012 and 2.8 percent in 2013.

So, the average annual growth rate of real GDP for the period 2011-2013 was 2.9 percent, which is the average of the three annual growth rates:

calculating formula for economic growth rate

When discussing long-run economic growth we will usually shorten average annual growth rate to growth rate.

We can judge how rapidly an economic variable is growing by calculating the number of years it would take to double. For example:
  • If real GDP per capita in a country doubles, say, every 20 years, most people in the county will experience significant increases in their standard of living over the course of their lives.
  • If real GDP per capita doubles only every 100 years, increases in the standard of living will occur too slowly to notice.

One easy way to calculate approximately how many years it will take real GDP per capita to double is to use the rule of 70. The formula for the rule of 70 is as follows:

calculating formula for economic growth rate
For example:
  • If real GDP per capita is growing at a rate of 5 percent per year, it will double in 70/5 = 14 years.
  • If real GDP per capita is growing at a rate of 2 percent per year, it will take 70/2 = 35 years to double.
These examples illustrate an important point:

Small differences in growth rates can have large effects Opens in new window on how rapidly the standard of living in a country increases.

Finally, notice that the rule of 70 applies not just to growth in real GDP per capita but to growth in any variable.

For example, if you invest $1000 in the share market and your investment grows at an average annual rate of 7 percent your investment will double to $2000 in 10 years.

What Determines the Rate of Long-Run Economic Growth?

Increases in real GDP per capita depend on increases in labor productivity.

Labor productivity is the quantity of goods and services that can be produced by one worker or by one hour of work.

In analyzing long-run growth, economists usually measure labor productivity as output per hour of work to avoid fluctuations in the length of the working day and in the proportion of the population employed.

If the quantity of goods and services consumed by the average person is to increase, the quantity of goods and services produced per hour of work must also increase.

Why in 2013 was the average Australian able to consume more than five times as many goods and services as the average Australian in 1901?

Because the average Australian worker in 2013 was more than five times as productive as the average Australian worker in 1901.

If increases in labor productivity are the key to long-run economic growth, what causes labor productivity to increase?

Economists believe two key factors determine labor productivity: the quantity of capital (both physical and human capital) per hour worked and the level of technology.