Mysteries of Growth

The standard measure of a national economy’s overall performance is its real gross domestic product (GDP). This is just the sum of all the goods and services produced during the year (except those used up in further production), valued at going market prices and then corrected for price inflation. The graph on this page shows yearly real GDP per person in the population of the United States from 1948 to 2000.

Two characteristics stand out clearly from the graph. The first is a rising trend, the statistical image of economic growth. If you were to pencil in a smooth curve it would rise from about $11,000 in 1948 to about $34,000 in 2000, or at 2.19 percent a year on average. But the rate of growth is not constant; there are intervals of faster and slower growth (for instance from 1990 to 2000 and from 1973 to 1983). The second characteristic is that real GDP per person fluctuates within this larger trend in what are often called business cycles, though the fluctuations are not very regular. The existence of business cycles suggests that it would be more accurate to plot the trend through the cyclical peaks than through the midpoints. That would reflect the commonly accepted notion that real GDP is more often below the economy’s normal capacity to produce than above it. This second sort of trend, from peak to peak, is usually called the economy’s “potential” output: not an absolute limit, but a level of production that cannot be exceeded for long without strain and likely inflation.

The distinction between trend and fluctuations is not merely descriptive. They represent different mechanisms. The conventional wisdom—which I believe to be correct—takes the general upward trend to be driven mainly by factors on the supply side: by improvements in the education, training, and skills of workers; by technological innovation; and by increases in the stock of machinery and equipment per worker as well as the replacement of obsolete equipment with new versions adapted to the latest and most productive technology. Of course education, capital investment, and innovation are not elemental forces. They result from choices and respond to pecuniary and other incentives.

The short-term fluctuations, on the other hand, are driven primarily by demand-side forces: by changes in the willingness and ability of families and firms (and foreigners) to buy goods and services. When real GDP falls below potential, it is not because some factor has diminished the economy’s capacity to produce, but because producers and sellers cannot find enough willing buyers at the prices they are charging. (Do not leap to the conclusion that a round of price reductions would cure this problem. Lower prices would mean lower incomes generally, and perhaps the expectation of further price reductions. Both are likely to lead to a further weakening of demand. The result might be little or no improvement in economic conditions.)

This way of looking at the trend in economic growth …

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