Long-run economic growth is explained by models that focus on how an economy's productive capacity expands over time. The Solow growth model, a foundational framework, attributes growth to three forces: capital accumulation, growth of the labor force, and technological progress. Output is typically described by a production function such as the Cobb-Douglas form \( Y = A \times K^{\alpha} \times L^{1-\alpha} \), where Y is output, A is total factor productivity, K is capital, L is labor, and α is capital's share of output. The model highlights diminishing returns to capital: each additional unit of capital adds less to output than the previous one when other factors are held constant, which limits how much capital deepening alone can sustain growth.
In the Solow model, economies tend toward a steady state in which capital per worker and output per worker remain constant because investment exactly offsets depreciation and population growth. Once at this steady state, further growth in output per worker requires technological progress, captured by total factor productivity (TFP), the portion of output growth not explained by increases in measured inputs of labor and capital. The Solow residual is the empirical estimate of TFP growth, calculated as the unexplained portion of GDP growth after accounting for capital and labor inputs.
Endogenous growth theory builds on Solow by treating technological progress as the result of internal economic forces rather than an exogenous gift. It emphasizes human capital, the skills, knowledge, education, and health of workers that boost their productivity, as well as innovation, research and development, and knowledge spillovers. By contrast to Solow's diminishing returns, these models can generate sustained growth without relying on outside technological advances, helping explain why some economies continue to grow rapidly for extended periods.
A useful way to gauge the economy's use of resources is the concept of potential GDP, the maximum sustainable output an economy can produce when labor, capital, and technology are fully and efficiently employed without generating excessive inflation. The output gap measures the difference between actual GDP and potential GDP: a positive gap indicates an overheating economy operating beyond its sustainable capacity, while a negative gap signals underutilized resources and slack. Closing output gaps is a central aim of stabilization policy, while raising potential GDP itself depends on the long-run drivers of growth: investment in physical and human capital, technological progress, and the institutional environment that supports productive activity.