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How does the economy "grow"? Answered

How does the economy "grow"? I've asked this question to a lot of people and never got a real answer. The news is always talking about the economy "growing" and that credit is the answer, but I don't understand the question. I understand the idea that you want more wealth to be flowing around and that means there is more out there to grab but what is making the economy bigger?



Best Answer 7 years ago

Human input (labor) grows an economy. Additionally, what we define as "worth" (the base unit of economy) in is subjective to human desire. Stylish clothes, pretty jewelry, cure for cancer - things that are important to humans, not the universe. So, there is a fundamental human point of view that is implicit in the question. Important, because these perceptions are outside of physical conservation laws.

Payment is used to stimulate human input. A good way of looking at money is exchange for our time (labor-hours). Differing amounts of money can prioritize tasks. If you are offered 200 for task1 - 1hr of work and you are offered 300 for task2 - also 1hr of work, you'll have incentive/priority to complete task2 first.

Credit can extend and further the available payment. Since "worth" is a created idea, we can extend it (non-conservation) by making future promises. "I'll pay you in the future for work done now" > we have an expectation of money and how it will continue to be valued in the future, and thus an expectation/trust of its value, so human input is traded for future payment.

Theoretically, as long as the increase in "perceived" worth / result of human labor is greater than the value of the credit / future payout, the "economy" has grown. If a research loan produces a cold-fusion generator, the value of that would be much greater than the loan.  Once the credit was payed, the net result would be a positive value in that economy.

Its quite simple. The STABILITY of the economy relys on the circulation of money within the country. The more money inside the circulation, the bigger the economy.

The reason our economy "shrinks" is because some of that money leaves the circulation. such things like our dealings with china. When we buy outsourced goods, the money goes to the foreign economy, and does not circulate back to the consumer through their jobs.

You're looking at your "zero-sum" theory too close, as if it were just an exchange between the consumer and the merchant, you're forgetting the circulation. If you worked at a metal factory and bought a vehicle, then a percentage of what you pay for the vehicle, will make its way back to you, and your payroll, because metal is bought so they can build the vehicle. Thats stabilization. Growth is when we sell one of those vehicles to an other country because it brings in outside profit, adding more dollars to the circulation.

Saying that credit is the answer to the growth of the economy is, in my opinion, rubbish. Its like filling a bag with air and saying there is now a bigger bag. The only thing credit does for the economy is ensure the circulation of money.


Fundamentally (and theoretically), production. Gross domestic product is the value of all the goods and services produced in the country, minus the cost involved in producing them. In a very simplified way, as factories make more and more things, but not all the things already made get discarded, the economy grows. Generalize that that to less material "things," and you'll get the picture.

Ok so I understand that, but doesn't that just shrink the economy somewhere else? For example the Speedy Car company makes it's Speedy cars and pays it's workers $10,000 on average to make the car, they pay $9,000 to buy the materials and tools etc, and $3,000 to sell it (showroom floor, salesmen etc). The price for a Speedy is $25,000 so the company gets $3,000 to cover overhead and profit.

But that doesn't matter because I spent the $25,000 on the car. My buying power is reduced because of it and therefore my very personal economy has shrunk. Speedy Car company's economy grows, but on the whole, there is a net of 0 change to the amount of resources that are in the economy as far as money is concerned.

This is where I really get confused, especially with the talk of "credit grows the economy". Since they are offering me to use the money that they have and I have to pay it back with interest, that actually further shrinks my resources (because of the interest) and therefore reduces buying power (but gives the credit companies the resources). This too is a net 0 to the overall "size" of the economy.

If factories are making more and more things, then supply goes up and the price will drop because there is only so much available buying power in the economy.

The only way I can really understand an economy growing is with population expansion.

Your personal economy has shrunk, but your personal income and expenses do not count toward GDP. You've already purchased the "durable good," so that production is counted.

Your "zero-sum" analysis is incorrect (it is excessively simplistic). I would highly recommend a good economics text (even an upper division undergraduate textbook would be sufficient).

You fail to take into account efficiencies of production, durability of goods, etc. You're also not taking into account that "money" is not a fixed, conserved quantity (i.e., it is not backed by gold or any other concrete material). Money is an abstract medium of exchange, whose value is determined only in relation to other monies in other domestic economies. The "available buying power" is not a constant -- it is as variable as the money supply.

I'm not saying that an economy can't grow, I'm saying that the explanation is not sufficient to explain the growth. GDP is a function of all the people in the country's income and therefore an individual's buying power is important to the GDP.

I haven't addressed efficiencies of production, durability of goods and that money is not a fixed quantity, but that doesn't mean that I haven't taken them into account. The conversation hasn't gone there yet.

Of course buying power isn't a constant, if it were then the economy couldn't grow. My question is "How does the economy grow?"

I don't know how durable goods enter into the picture (I'm not saying they don't, I'm saying I don't have enough information). Do they mean that I don't have to buy the same item next year so I have more available money the next and subsequent years?

The main way I see an economy growing is by having more man hours or higher pay for man hours. The problem I have with that is it's too simplistic. You could simply raise minimum wage and suddenly your economy is bigger but then either businesses can't have as many employees or it makes inflation go up and therefore kills any gain.

Population growth means more available hours that can be worked but you can't just keep growing your population because there are only so many jobs.

Available money determines how many jobs a business creates but that's a chicken and the egg problem. In a shrinking economy you need more money to make more jobs.

More resources for production (whether raw materials, higher efficiency, input energy, whatever), means more production. If prices remain fixed, that means more income for the producers (I assume here that demand balances supply, a given with an efficient market). If prices remain fixed, that also means production costs remain fixed as a percentage (you buy more resources, but use them to make more pig stickers).

Durable goods are a useful proxy of GDP for exactly the reason you state. They are only purchased intermittently, so the cost doesn't have to be considered recurring for any individual purchaser. However, since they rotate through the economy randomly, there are always some being purchased (as the older ones retire from use).

Increasing employee output is one way for the economy to grow. Another way is to increase efficiency -- be able to produce more pig stickers with the same number of man-hours. I think, in the long run, that turns out to be the dominant factor (interchangable parts, mechanization, assembly lines, robots, blah blah blah).

So durable goods are an indicator of growth but not the cause of growth? I can readily understand that. My take on durable goods is they are in essence the same as non-durable goods, just the period (or frequency) between purchases is greater.

Efficiency then is the primary engine of economic growth? A small efficiency theoretically would logarithmically build on itself so I could see that but then price of the object typically drops as efficiency goes up. The first company to implement the efficiency gain gets a big benefit, but then others implement it to remain competitive, prices drop and sometimes the benefits are completely absorbed by the price drop.

Seriously not trying to be difficult here, but these are the things I know can or do happen so it leaves me wondering. I'm not saying you're wrong, I can easily see marginal gains through efficiency, my contention is that economy measures money and not the more efficiently produced goods. It also doesn't get to the heart of the matter. More money is coming into existence. We already discussed the central banks and them producing more money but they don't just walk up to more efficient manufacturers and say "here's more money".

I imagine that the oft cited "credit is vital for the economy to grow" statement is the key here but I have a problem with credit since it is a net drain on profits in the long term. I have a problem with something that will in the end cost more money making the economy grow.

For instance, HSBC borrows from the central bank (money that they just printed) but they have to pay it back with interest. Now I know that they just re-loan the money out at a higher rate (even if just slightly higher) and so make a profit. However, the business that is being loaned the money now has it's long term buying power reduced. That to me would seem to shrink the economy except that you just added money to the pot and that won't go away until the fed bank is paid back more than they just injected into the economy. The fed can re-loan that money but it keeps getting paid back (What does the fed do with those profits? Do they go into the government's coffers?). I'm trying to figure out the point where this money is now getting traction in the economy.

Keep extending your example. HSBC borrows money and relends it at a higher interest to make more profit. Those businesses use the borrowed money from HSBCuse it to improve their business (build a new plant, update equipment, etc) or use it in some other way such that they, in turn, get more return from their improvements than the amount of interest they are paying. Thus both the HSBC and the borrowing companies are able to use that money to increase their respective future buying power and there is no net drain on the economy because without the loan, the improvements would not have happened or happened much later.

Without the loan from HSBC, the company would have to wait months, years, or even decades before they could afford to make the improvements using cash on hand. In this scenario it takes much longer for companies to grow and therefore the economy as a whole grows much more slowly, if at all. The effects can be multiplicative as well because improvements build on each other making the economy more and more efficient and therefore it grows more quickly. Without credit, the slope of the improvement curve goes way down.

As for where the money the Fed gets on the money it loans, that money is essentially taken out of the economy until such time as the Fed chooses to relend it. The fed is there to regulate the amount of currency in the economy, not to make a profit.

Hey good answer paperrhino.

Okay, I've been digging into economic theory as you've been telling me to do. Here's what I found.

Economic growth depends on the available labor and capital. If there is not enough labor available then labor efficiency comes into play. If there is not enough capital then labor cannot be employed. In essence the ability to employ labor is the key.

The classic problem is all business would like to "do more business" but there is a limit to the amount of available capital that permits them to employ more labor.

Credit is used to enhance the amount of capital that a business has and now can hire more labor. Most credit or investing comes from the private sector in good times.

Most fed bank lending tends to be an attempt to supplement the available capital in bad times. The main point of these loans is to cover the required cash reserves of the banks. If the loans from the fed are used to do more than that, then there will be inflation.

That actually answers most of my quandary except one thing I can't get over the idea that the Fed is long term injecting money into the economy by lending. In the short term yeah, no problem but if the bank borrows $1 and pays the fed back $1.0000001 then the fed has just removed money from the banking system and therefore the total available capital. I understand the net benefit, more people are being employed and therefore there is a larger market but in the long term money is removed from the system (unless the interest rate is 0% which is just plain weird). Is this what treasury bonds are for?

Taking money out of the system isn't necessarily a bad thing. One of the Fed's jobs is to regulate the amount of money in the economy. That means both increasing the amount of money AND decreasing the amount of money. They are trying to walk a tight rope where off to one side is high inflation (too much currency in circulation) and on the other is deflation (too little currency in circulation). Typically, the Fed likes for there to be just a little bit of inflation.

The Fed has several ways of doing this. One way to add money is to lower the interest rates. This encourages the banks to borrow more from the Fed and it reduces the amount of money the Fed takes out of the economy through the interest rate. One way it can remove money from circulation is to raise the interest rate. This discourages the banks from borrowing from the Fed and it removes more money from circulation because of the higher interest rate.

Treasury bonds represent loans the federal government takes out to cover the spending deficit. The Fed is the single largest holder of US treasury bonds and they sometimes use them as another way to increase or decrease the amount of currency in circulation by buying or selling treasury bonds. Buying bonds increases the amount of money in circulation and selling decreases the amount of money in circulation. This is because the monetary value of a bond is not actually circulating in the economy. It is just sitting there quietly earning interest, waiting for the bond to be cashed at the Fed. Until the bond is cashed at the Fed, all the money and interest earned on that bond is not participating in the economy (I'm ignoring the bond markets for simplicity) and therefore not circulating.

At the current time, the Fed has held interest rates at 0% and very near 0% which means that the only way they have to inject additional money into the system right now is to buy treasury bonds. It appears that the fed is worried that there isn't enough inflation at the moment (a little bit of inflation isn't bad), they fear we will slide into deflation (which is really bad), and/or they want to improve US exports by lowering the relative value of the dollar (a cheaper dollar means that our products are cheaper overseas).

It strikes me that no-one is considering the effect of international trade, and rising living standards in OTHER countries driving economic growth.


I could see how international trade would temporarily make a local economy grow. You have more customers. Still, that trade is ideally two way and could in fact make a local economy shrink if you're a net importer.

It's a valid point. I think I'm focusing on domestic growth though and specifically how credit can make an economy grow.

We've pretty well proved credit can't make an economy grow in the long. Keynesian's will say that credit does make it grow, but even they acknowledge that the injection of liquidity has to be temporary, or like others have said, its inflationary.

More people working to make more stuff than last year, or the same number of people getting better at making stuff so that there is more stuff than last year. "Economy" is a fancy way of saying "money flow"-an economy gets bigger when more money flows (more stuff made and sold).

But doesn't the money have to come from somewhere? If I make an infinite number of pig stickers (I'm really trying not to use the W word here). That does not mean an infinite economy because there is only so much buying power (or money to buy with) available in the economy.

Money comes from the national central banks. It can be created or removed from the economy (hence the term "money supply").

Yes the physical money does come from the central banks, no question, but why do they produce more money and under what conditions do they hand it out? I know central banks make loans, are they just printing the money to cover these loans?

In other words, the physical money is there to represent value and so in theory, the bank should demand something of value for their printed money. Am I wrong there?

Yes, you're wrong (no, you're not wrong, just a bit too simplistic). First, give up the idea of "physical money." The number of pieces of paper with dead people's pictures on them is quite small compared to the amount of "money in circulation." Nearly all financial transactions in developed countries are purely electronic.

Central banks have two "levers" (if you will) by which they can affect (or effect :-) the macroeconomy. They can change the interest rate they charge to banks for borrowing money from them. That affects how much money "trickles down" to producers and consumers because banks can't loan money they don't have.

Second, the central bank can directly add money into the economy. They do this by buying back bonds (Treasury notes, in the U.S.), or by directly printing more physical currency for bottom-level consumers. The "quantitative easing" used in the U.K. and the U.S. is of this form.

Your theory about the value of money is correct at the lowest level (consumers), but not so much in macroeconomics. The central banks don't receive anything in exchange for the money they distribute, except other money.

What "makes the economy bigger" is more business being done, and more profits being made, and more salaries being paid, which lets people buy more, which causes more business to be done, which...

*IF* the economy is being limited by the availability of loans to invest in starting new businesses and expanding old ones -- which is part of the problem right now in the US -- then the government may try to counter that by lowering interest rates, by increasing the monetary supply, or both. As others have said, there are unpleasant side effects from these actions, so they have to be considered *very* carefully.

There really is no simple answer to how to balance this -- even expert economists can disagree -- and some of it is just a matter of being cautious about not doing anything too large too fast and not doing anything you can't correct for if you overshoot.

All of which is why a good Fed chairman is a gift from the gods. And which is why the mess that the Bush administration left us will take more than two years to clean up.

I understand it's complicated, but I like complicated. The problem is that these are all very general answers that don't really answer the question, they just re-state it. My contention is that a business that is doing "more business" has to make it's money from somewhere. If money is coming from somewhere then it is just a reshuffling of money and not actually expanding the overall scope of the economy.

In general a business does more business by being more efficient (as noted by kelseymh) or by hiring more workers. I also think that paying workers more may have a function here also but as I've stated that can just lead to inflation. That also doesn't make a business "do more business" but it does give them customers with deeper pockets and therefore may sell more to them.

Is it the loaning of money to hire more workers that makes the economy grow? If the company doesn't have more money, it can't hire more workers, but if it gets a loan, it will have the potential to do so.

Maybe the productivity gain from hiring a new worker is greater than the long term cost of the loan?

You still seem to be missing the basic issue. The money supply is not a constant!
In physics terms, there is no law of conservation of currency. Balancing the books is only for microeconomic accountants :-)

For any given national economy, money flows in from foreign investors, it flows out to foreign investments, and the central bank can create new money out of nothingness (sovereign credit).

Once you wrap your head around the fact that, at the very top level, you really do get money for nothing, then I think all of your other considerations resolve themselves.

The fact that money is not a constant is not lost on me, but it is relatively constant because of the issues that crop up if printing more money is not done carefully. Other than the fed printing money, supply is constant (ok aside from using foreign currency). But if that is true then only the fed can enable the economy to grow.

Maybe that is a key point? The printing of money only allows the economy to grow and only when the economy is ready to grow or you have inflation?

It isn't magic with no explanation. It's a basic idea and people are talking about it all the time but no one seems to understand it. There has to be a mechanism that is the basis for economic growth. There are hundreds of countries and all of them have accountants and economists (of varying degrees of competence). Someone somewhere has to have some idea.

Saying the economy grows because businesses do more business is the same as saying the economy grows because it does more economic activity.

The problem with that is all businesses want to do more business but have limited resources and limited markets. The market has a certain financial potential because each of the many people or businesses have a limited amount of currency. With that in mind, the GDP is defined by the amount of money the customers have to buy with. This is then reduced to the number of customers multiplied by their average income. If you increase your customer base (population expansion or new trade partners) or the average income of your customers, then the GDP will grow. These two things are limited by the available money in the economy because in order to have income you must have jobs. It thus becomes a circular thought process. Businesses need to pay more people a larger average income but the business needs more income to pay more and higher wages.

This is where I think the loans come into play to make the economy bigger. The loan allows the employer to do hire more people at higher wages (usually not directly but it frees up money to do it). However future profits are reduced and therefore future expansion is reduced. Therefore this is not a mechanism for overall growth.

Efficiency means more production for less money, but the market side does not change so the amount of money to purchase the increased production has remained the same so demand is constant (again relatively) supply increases, and price drops. In truth efficiency is usually used to reduce the costs of producing a product, the supply is kept constant and workers are laid off, which means a smaller total economy down the road unless those workers aren't picked up somewhere else. So efficiency could in some cases shrink the economy.

If you're totally sick of me by now I don't blame you. It's just that I'm still not getting where people get the idea that credit is vital for economic growth. In my limited understanding, it should be wages that need to be boosted to drive economic growth.

It still sounds like you're assuming a zero-sum game, and it's not. Even putting aside the fact that the money supply isn't conservative (and that is a large effect, not small as you assume).

Central banks can supply more money to the economy by lowering interest rates, since they maintain a large reserve. When interest rates go down, banks are more likely to borrow money in order to pass it on (whether as direct loans to businesses, or buying investments). The present situation in the U.S. is that the Federal funds rate is already set to 0%, so "quantitative easing" (putting more money out into circulation) is the only available lever.

Aggregate demand, whether at consumer level or higher up the food chain, is no where near saturated. New businesses can appear out of nothing and produce things for sale, which will be bought. That will not necessarily take business away from other companies. I am certain that you can find specific counterexamples with specific products, which is why I was careful to specify "aggregate."

Aggregate supply is not saturated either. Therefore, if demand for something increases, more can (relatively) easily be made without having any effect on price or on cost. The same argument as above applies here.

Basic economics discussions generally assume that demand and supply are both saturated (and hence in equilibrium), but real national-scale economies rarely operate in that regime. You seem to be making the same assumption in your analysis, and that might also be part of your confusion.

You have really gotten caught in very complex details, and a simplistic "Econ 101" analysis is woefully inadequate. You need to move away from Q&A and do some upper-division or graduate level reading on macroeconomics, national monetary policy, and so forth.

The detailed answer is beyond my abilities, and is probably on the order of a college-level textbook. May I suggest hitting the library?

Fact of the matter, theres a deficit. This basically means 'we' (the first world in general) are spending more than we are making. In many cases it's we need to spend more than we are making - so what does the government (they who are in charge of the money supply) do? They lend money they don't have. How do they do that? In the most literal sense they print more money. Problem is, as kelseymh says, there is a fixed amount of value in a country -and that value is divided among the amount of currency out there. If you dilute that value by making more currency, the money becomes worth less and less...

I think you're getting to what I'm thinking about but there has to be a point where that manufactured money is not diluting the economy and is making it grow. What is the mechanism that allows that money to go into the economy without reducing it's own value?

Now you're asking a good, and very complex, question. People get Ph.D.s in economics for trying to answer it, so you aren't going to get a sound-bite answer from us.

This is the fundamental problem central banks have: they can create new money and add it to the economy, either directly or indirectly (by reducing the interest they charge to loan money to banks). If they do too much of that, you get inflation (prices rise without increasing value, equivalent to the currency devaluing). If they do too little, you get deflation and recession. Finding the right balance is why central bankers get paid big bucks.

If this is a subject in which you're interested in over the long-term, I would strongly recommend that you subscribe to The Economist. Besides the great coverage of international news (something almost entirely missing from U.S. media) and science (the most accurate science writing I've found outside of peer-reviewed journals), you also get excellent lessons in economic theory.

Their "Economics Focus" column covers some topic of interest which has been published in the recent literature. Within six months to a year, you'll have gotten as good an overview of modern economic principles as you could from an undergraduate University course. And the writers don't assume you're not a drooling idiot.