Economic growth is most often described as growth in GDP. Several factors have been shown to influence the growth and level of GDP:
- Savings and investment is positively correlated with economic development. For countries to grow, private and public sector investment must provide a sufficient level of capital per worker. If a country has insufficient domestic savings, it must attract foreign investment in order to grow.
- Financial markets and intermediaries augment economic growth by efficiently allocating resources in several ways. First, financial markets determine which potential users of capital offer the best returns on a risk-adjusted basis. Second, financial instruments are created by intermediaries that provide investors with liquidity and opportunities for risk reduction. Finally, by pooling small amounts of savings from investors, intermediaries can finance projects on larger scales than would otherwise be possible.
Some caution is in order, however. Financial sector intermediation may lead to declining credit standards and/or increases in leverage, increasing risk but not economic growth.
- The political stability, rule of law, and property rights environment of a country also influence economic growth. Countries that have not developed a system of property rights for both physical and intellectual property will have difficulty attracting capital. Similarly, economic uncertainty caused by wars, corruption, and other disruptions poses unacceptable risk to many investors, reducing potential economic growth.
- Investment in human capital, the investment in skills and well-being of workers, is thought to be complementary to growth in physical capital. Consequently, countries that invest in education and health care systems tend to have higher growth rates. Developed countries benefit the most from post-secondary education spending, which has been shown to foster innovation. Less-developed countries benefit the most from spending on primary and secondary education, which enables the workforce to apply the technology developed elsewhere.
- Tax and regulatory systems need to be favorable for economies to develop. All else equal, the lower the tax and regulatory burdens, the higher the rate of economic growth. Lower levels of regulation foster entrepreneurial activity (startups), which have been shown to be positively related to the overall level of productivity.
- Free trade and unrestricted capital flows are also positively related to economic growth. Free trade promotes growth by providing competition for domestic firms, thus increasing overall efficiency and reducing costs. Additionally, free trade opens up new markets for domestic producers. Unrestricted capital flows mitigate the problem of insufficient domestic savings as foreign capital can increase a country’s capital, allowing for greater growth. Foreign capital can be invested directly in assets such as property, physical plant, and equipment (foreign direct investment), or invested indirectly in financial assets such as stocks and bonds.