What Is Growth Accounting?
Growth accounting is a quantitative tool used to break down how specific factors contribute to economic growth. Growth accounting focuses on three primary factors: the labor market, capital, and technology.
- Growth accounting is a quantitative tool used to break down how specific factors contribute to total GDP growth.
- The growth accounting equation primarily looks at three factors: labor, capital, and technology.
- The concept of growth accounting was introduced by Robert Solow in 1957.
Understanding Growth Accounting
The concept of growth accounting was introduced by Robert M. Solow in 1957. Solow was an American economist and a Professor Emeritus at the Massachusetts Institute of Technology. His concept has also been referred to as the Solow residual.
Solow provided economists with a tool for quantitatively breaking down gross domestic product (GDP), the primary economic growth statistic. With the growth accounting model, Solow brought technological advancement onto the stage as a GDP contributor. Prior to 1957, economists had mainly focused on the impacts of labor and capital investments.
The growth accounting equation is a weighted average of the growth rates of the factors involved. Solow’s economic growth accounting model looks at three factors: labor market growth, capital investment, and technology. Capital investment is often the key component obtained from statistical data releases. Solow also introduced technological progress as a third factor to explain the residual gap.
The Growth Accounting Equation
To calculate the growth accounting equation, economists must obtain the following key data points:
- GDP: annual growth and annual GDP. Annual GDP is reported by the Bureau of Economic Analysis (BEA) in the U.S.
- Labor: annual growth and annual contribution
- Capital: annual growth and annual contribution
The growth accounting equation is as follows:
GDP Growth = Capital Growth*(Weight of Capital Contribution) + Labor Growth*(Weight of Labor Contribution) + Technological Progress
Labor growth accounts for the remainder of inputs after capital or vice versa depending on the data used. Technological progress is the residual growth. Without technological progress, the equation wouldn’t balance. With technological progress, the equation shows how technology is influencing production.
Growth Accounting Factors
While the growth accounting equation can seem somewhat simple, identifying the data factors and calculating it can be tedious. The Conference Board (CB) can help as it provides an annual breakdown of economic growth accounting by region.
Below is a look at the growth accounting factors along with one-year data results for a nation, Investopedialand.
- GDP: Investopedialand's annual GDP was $20.5 trillion while the GDP growth rate was 2.90%.
- Capital: Adding capital to the economy should, among other things, increase productivity. Capital investment is of key importance to the growth accounting equation. Capital investment was $3.65 trillion for a capital contribution of 17.82%. Capital investment grew from $3.25 trillion at a growth rate of 13%.
- Labor: Labor looks at the number of people employed to identify a growth rate. Typically, more workers will generate more economic goods and services. In Investopedialand, the labor market for full-time workers grew from 125.97 million to 128.57 million or 2.06%. Its weight is identified by subtracting the capital weight, considering that capital and labor are the only two factors. Thus, labor would have had a weight of 82.18%.
- Technology: In the growth accounting equation, technology is a third residual factor. Cutting-edge technology can bring many benefits, including facilitating greater output with the same stock of capital goods.
Using the above example, Solow’s growth accounting model can be calculated as:
2.90% = 13%*(17.82%) + 2.06%*(82.18%) + Technological Progress
The technology factor turns out to be -1.11% in 2018.
The CB uses a two-year average with some slightly different data pulls.
Growth accounting is generally used by economists as one way to break down the percentage of a country’s economic growth coming from key factors. Solow’s economic growth accounting model looks at three key factors which provide a simplified view.
The BEA also provides contribution values using a similar methodology to Solow in its regular GDP reports but with more factors. In 2018, for instance, the BEA reported the following contributions to GDP growth:
What Is the Solow Residual?
The Solow residual is the remaining piece of the observed GDP growth rate that cannot be attributed to the growth in inputs of capital or labor. It is named after the economist Robert Solow, who speculated that the state of technological advancement could be a key contributor to this residual. This leftover piece of growth is sometimes referred to as total factor productivity (TFP).
What Is the Difference Between Growth Accounting and Development Accounting?
Development accounting analyzes the differences in growth factors observed across different countries. Growth accounting only looks internally at the growth factors within a single country.
What Are the Assumed Shares of Capital and Labor to Economic Growth?
The weights of the relative contributions of capital and labor to economic growth have traditionally been assumed to be 0.30 for labor and 0.70 to capital. In reality, these wights may vary, and economists can make adjustments to them as needed.