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What determines long-run growth?

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NET (Page 1) NationalEconomicTrends September 1997 What Determines Long-Run Growth? In the first quarter of 1997, real gross domestic product (GDP) grew at a surprising 4.9 percent annual rate. The general consensus among economists is that this is not a sustainable rate. So how fast can the economy grow? The level of output of an economy is determined by the level of inputs (land, labor and capital) used and the production methods used to convert the inputs into goods and services. Output can only be increased through additional inputs or more efficient use of available inputs. How fast we can increase inputs is limited, however: Land is essentially fixed. Population growth and participation rates determine the size of the labor force. In less-developed economies, a large fraction of inputs are underutilized and the level of capital is usually low. These economies can grow rapidly by increasing inputs and/or by increasing production efficiency—for example, by moving toward state-of-the-art technology and raising the level of education. A developed economy like the United States, starting from a higher level of input use and efficiency, has less margin for high rates of growth. Innovation and improvements in existing technology are the keys to increased growth rates. The conventional wisdom is that the potential growth rate of the U.S. economy is between 2.0 and 2.5 percent annually. This range reflects a projected growth in the labor force of about 1 percent and a trend growth of 1.0 to 1.5 percent in labor productivity (output per hour), which captures capital accumulation and technological improvement. The chart shows the historical index of business labor productivity and the labor force in logarithms, so that the slopes of these graphs are the growth rates. Both variables show a distinct reduction in slope at different points. Average growth in business productivity slowed from 3.3 percent annually before 1973 to 1.2 percent annually after 1980. The growth in the

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