Firstly, one of the main determinants is capital. As a result, an increase in capital through investment will increase output. Investment will only raise output depending on the productivity of this new capital which is called marginal efficiency of capital.
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Physical capital is essential as workers are more productive and they are able to work more quickly and accurately by having the right tools. Furthermore, the quality of labour (education) determines human capital. Investing in education is similar to investing in physical capital. Consequently, investing in secondary schooling is considered one of the most effective ways that developing countries can increase their growth. Also, this is also showed in the UK budget 2010 where they are giving 20,000 additional places at undergraduates as it is seen as vital to the economic recovery (telegraph, 2010).
Figure 1 shows the student test scores versus GDP per capita. The correlation between GDP and test scores, although not perfect, is strong (economic growth, pg.179). Countries that devote a large share of GDP to schooling, such as UK and Singapore, tend to have high growth rates. Countries that devote a small share of GDP, such as Mozambique and Nigeria, tend to have low growth rates.
Figure 1: Student Test Scores vs GDP per Capita
In addition, human Capital includes the size of the labour force. If there is an increase in the working population then there will be an increase in potential output. Population growth has a positive impact on GDP as more people bring stimulus to demand, investment and income. Since 1945, labour input has risen mainly because more women have joined the labour force (Begg, pg. 517)
Both physical and human capital directly impact on the productive capacity of an economy, as there are more resources available. They are complements of each other as one cannot work with a tool if one does not have sufficient education and skills. For example, after the 2nd World War in Germany, physical capital (land, infrastructure) was destroyed, but the skills of the labour force allowed Germany to be one of the countries that recovered most rapidly after 1945 (Begg). Moreover, growth per capita was very small in the past but after the 1750 industrialisation the capital and knowledge that was gained by one generation was accumulated by the next and this resulted in a much increased GDP (Economist). This shows that both types of capital are essential for economic growth.
Moreover, natural resources also contribute to economic growth but there is a limit as to how much can be exploited. For instance, oil is a non-renewable resource and when it is depleted, we will not be able to create more. Also, the land that a specific country owns will always stay the same, unless it is conquered by another country. Therefore, natural resources contribute to the economic growth but they are not necessary for an economy to be highly productive. For instance, Japan is one of the richest countries but does not have many natural resources (Mankiw and Taylor, pg. 508).
Furthermore, technology is another key determinant of economic growth. The new growth theories examine factors that ââ‚¬Å“determine why technology, research, innovation and the like are undertaken and how they interactââ‚¬ (LeRoy). Technological improvements (such as computers) increase the marginal efficiency of capital (which is the additional output resulting from the use of an additional unit of capital) and new machines give a higher rate of return as technology can replace workers. Innovation also allows us to transform objects into forms that provide greater growth. The New Growth Theory also implies that we continue to increase living standards by steadily improving our knowledge of how to produce more and better goods and services with ever smaller amounts of physical resources (Grossman and Helpman, 1994).
Knowledge and education are equally important. Romer (1968) argues that production and manufacturing knowledge is just as important as other determinants. He believes that knowledge is itself a factor of production and economies should invest in it, just as they invest in capital and machines. This is why knowledge and education will affect economies in a long term as more people will be able to contribute ideas, invent new products and build on ideas of others for the economy to move forward.
Figure 2 shows the productivity (GDP per worker) levels in 1993. For decades, UK has invested a smaller proportion than other countries. Few of the causes of this poor performance comparing with other countries are that: UK had been slow to exploit the commercial potential of new technologies, the workforce had not had the skills necessary to adapt to changing economic conditions and to innovate and the amount of investment has been poor comparing with international standards (Treasury). Since then, UK has increased investment in human capital, technology and innovation. This resulted in Figure 3, where the reduction in the UKââ‚¬â„¢s output per worker gap with France, Germany and the US from 1995 to 2005 (after 10 years) is showed. The treasury reported that UK in 2006 was now experiencing its longest period of combined productivity and employment growth since the 1950s.
Figure 2: Productivity (GDP per worker) levels in 1993
Figure 3: International comparisons of output per worker (treasure, pg.3)
It is also reasonable to expect that, if other things equal, a greater commitment to innovation and research and development will accelerate technical progress and hence productivity growth (Economic Growth in Modern Britain, pg. 45). This is due to increasing use of technology that enables introduction of new and superior products and processes. This role has been emphasised by various growth models and many studies (Fagerberg, 1987; Lichtenberg, 1992; Ulku, 2004 (working paper)). However, R&D is quite risky because the economy does not know how much to invest in it and if they will actually find something new. This is why an economy needs to have a skilled and educated labour force in order to succeed in R&D.
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In the pre-budget of 2009, UK has more than doubled public investment and encouraged private sector investment through the R&D tax credit. The Government has announced that it will introduce a Patent Box to strengthen the incentives to invest in innovative industries and ensure the UK remains an attractive location for innovation. (innovation pg. 66)
Another major contributor to economic growth is investment and savings. Solowââ‚¬â„¢s Growth Model emphasises the importance of investment in an economy (Working paper). Most determinants of economic growth depend on investment like: capital, education and technology. In order for capital goods to be accumulated to produce greater quantities of consumer goods in the future, consumer goods have to be given up in the present. For growth to occur the level of investment has to be greater than the amount of depreciation.
The higher the level of investment above depreciation, the greater the potential output of the economy in the future. Unfortunately, the resources to enable investment have to come from somewhere and this is achieved by an increase in savings by households. Higher saving rates contribute to higher investment and hence increase capital accumulation and economic growth.
The analysis above gives the traditional Production Possibility Frontier(PPF) model of economic growth. In the figure below, a country starting with high levels of current consumption will have few resources available for investment. Its PPF will increase only slowly, if at all. A country succeeding in restricting consumption today will have an expanded PPF in the future, and can move to a point of higher consumption and higher economic growth (factors determining economic growth).
Figure 4: Production Possibility Frontier
Free trade also supports economic growth as it encourages a more rapid spread of technology and industrial ideas. Open markets affect economic growth through several channels such as exploitation of comparative advantage, technology transfer and diffusion of knowledge, increasing scale economies and exposure to competition (working paper). Poor countries that are open grow faster on average than rich countries because openness leads to economic convergence and the speedup of growth (graph pg. 326 table 11.1). In figure 5, we can examine the economic opening of Japan in 1858. It shows the price of two goods, tea and sugar, which before the opening were equally valuable. However, as soon as Japan began to trade, the price of tea rose and of sugar fell. Japan could now export tea at a higher price and import sugar without processing it domestically. It had a comparative advantage in the production of tea and within two decades was exporting 24 million pounds of it annually.
By increasing competition between countries, efficiency improves and it increases the incentives for technological innovation. Trade encourages economies to discover ways to specialise so that they can become more productive and earn higher incomes. However, not all economies can benefit from free trade because they do not all have the means to technological progress or enough knowledge.
In conclusion, economic growth is an important topic because it has such a significant impact on the welfare of many people. It is a field of active research, in which ideas are constantly being processed; new models are built, debated and tested. One can see that all determinants are interlinked and contribute to a long-term economic growth.