2.1 Economic Growth
YEAR 12 MACROECONOMICS 2021 -22
Introduction
Economic growth is the rate of change in real GDP of an economy over time.
Recall that nominal GDP is the total value of final goods and services produced
within an economy in a given time period, measured at current prices.
Real GDP is the total value of final goods and services, measured at constant
(base year) prices. Thus, real GDP removes the effects of inflation and allows for
comparison over time.
When making comparisons across countries, we often use real GDP per capita.
We also distinguish between short run and long run economic growth.
Real GDP in the UK (Source: ONS)
Short run economic growth
Short-run economic growth is an increase in the real GDP of an economy over a given
period of time, utilizing current resources and technology.
Short-run growth is actual economic growth: it reflects an increase in actual real output
(as opposed to ‘potential output’).
Capital
goods
B
KB
KA
On the production possibility curve
(PPC) diagram, actual economic
growth is shown by a movement from
an output combination at point A to
point B, where more of both capital
and consumption goods are being
produced.
A
PPC
CA
CB
Consumer goods
Causes of short run economic growth
Recall from the AD-SRAS model that short run equilibrium real GDP can increase
due to an increase in either aggregate demand or short run aggregate supply.
Can you recall the definitions of aggregate demand and aggregate supply?
Make sure you can list all the factors that cause AD and SRAS to increase and
explain why (see earlier notes).
Aggregate demand and short run economic growth
Recall that AD = C + I + G + (X – M).
Therefore, any increase in a component of aggregate demand – consumption,
investment, government spending or net exports – will result in an increase in
aggregate demand (shown by a rightward shift of the AD curve).
Reminder of some of the factors that can cause AD to increase (not an exhaustive list):
•
•
•
•
•
Increase in income or wealth
Increase in consumer confidence or business confidence
A lowering of interest rate
Higher government spending or lower taxes
An increase in net exports (due to changes in the exchange rate or relative inflation)
Short run economic growth caused by an increase in aggregate demand
Price
Price
Level
Level
SRAS
SRAS1
An increase in aggregate demand
(shown by a shift from AD1 to
AD2) leads to an extension of
SRAS. Actual real GDP increases
from Y1 to Y2.
PL2 PL2
PL1
AD2
AD1
AD
1
Y1
Y2
Real GDP
Aggregate supply and short run economic growth
Recall that anything that lowers firms’ costs of production will lead to an increase in
short run aggregate supply.
Some factors that cause an increase in SRAS (not an exhaustive list):
• Fall in the price of raw materials
• Fall in the price of imported components
• Reduction in real wage rates
• Lower costs of finance for firms and lower corporation tax
Short run economic growth caused by an increase in aggregate supply
Price
Price
Level
Level
SRAS1
SRAS1
SRAS2
PL1
PL
PL22
AD1
AD
Y1
Y2
Real GDP
An increase in short run
aggregate supply (shown by a
shift from SRAS1 to SRAS2) leads
to an extension of AD. Actual real
GDP increases from Y1 to Y2.
Anderton p205-6: Economic growth in the UK
Read the extract on p205-6.
How it Happened - The 2008 Financial Crisis: Crash Course Economics #12 –
YouTube
The financial crisis - 10 years on (adobe.com)
a) Using Figure 10, what can you say about economic growth in the UK during
2000 to 2014? Remember ‘ends, trends and bends’.
b) Based on the extract, how did the various components of aggregate demand
contribute to the recession following the 2007-8 financial crisis?
Suggested answers:
1. Economic growth was just above 4% in 2000, while by 2014, it had fallen to roughly 2.5%. Economic
growth was fairly volatile during this period, and the overall trend was negative. The economy
experienced a negative growth rate from approximately 2008 Q2 to the end of 2009.
2. Consumption was low because households were already indebted and did not want to spend more
through borrowing. There was also an increase in income taxes in 2010, a freeze on public sector pay
between 2010-14 and global commodity prices were rising. These led to further decrease in
consumption spending.
Investment in new capital goods by firms fell because of a lack of domestic demand and foreign
demand for UK exports.
Government spending went down and taxes went up, in an effort to cut the budget deficit (new ToryLib Dem coalition government in 2010).
Net exports fell because UK’s trading partners, especially the EU, were also in a recession.
Thus, there was a fall in all components of AD (C, I, G and NX), leading to a fall in short run economic
growth.
Anderton p207: Data Response Question – use specific figures
wherever possible
1. A recession is typically defined as real GDP falling for two consecutive quarters.
From the data, we can see that Portugal and the Eurozone as a whole experienced a
negative rate of growth of (nominal) GDP from roughly the middle of 2008 to the middle of
2010.
Portugal slipped back into negative growth from 2011 to 2013, while the Eurozone
experienced a milder recession between 2012 and 2013.
2. Investment is the addition to the capital stock of an economy. The capital stock is one of
the factors that determines the potential output of an economy (long run economic
growth).
The data shows actual output or short run economic growth. Nevertheless, we can see a
positive link between the growth in investment (Fig 15) and growth in output (Fig 12). For
example, for Poland, a steady growth in investment during 2005 to 2007 was accompanied
by an increase in short run economic growth. During 2012, Portugal had the largest decline
in investment and also the lowest growth rate of real GDP.
Anderton p207
3. ‘Economic performance’ can be measured by looking at economic growth / unemployment/
inflation and the current account on the balance of payments.
Growth: Poland seems to have fared better than Portugal/Eurozone. Even when Portugal and EU
were in a recession, Poland was experiencing a positive (though falling) rate of growth of output.
Unemployment: Between 2001 and 2007, the unemployment rate in Poland was much higher
than that in Portugal and EU. However, 2008 onwards, the situation was reversed.
Inflation: Poland had higher inflation than Portugal/EU for substantial parts of the period 2001
to 2016.
There is no data on the net exports or the current account. We also do not have any
information on consumption. Therefore, it is not possible to say conclusively whether Poland’s
economic performance was better or worse than Portugal/EU. However, it is possible to say that
Poland experienced stronger economic growth during this time (perhaps at the cost of higher
inflation).
Long run economic growth
Long run economic growth is an increase in an economy’s potential level of real output
over time (an increase in the productive capacity of an economy).
Note that we are looking at potential real GDP, as opposed to actual.
Capital
goods
PPC2
PPC1
The economy has increased its
productive capacity, as shown by the
production possibility curve shifting
outwards from PPC1 to PPC2.
Consumer goods
Causes of long run economic growth
An increase in the long run aggregate supply of an economy will lead to an
increase in potential real GDP.
Recall that anything which increases the quantity and quality of factors of
production will increase long run aggregate supply; this is shown by the LRAS
curve shifting to the right – see section 1.3.
Also recall that the LRAS curve can be drawn as neoclassical or New Keynesian.
Neoclassical LRAS
Price
level
LRAS1
Yf1
New Keynesian LRAS
LRAS2
Yf2
Price
level
Real GDP
LRAS1
Yf1
LRAS2
Yf2
Real GDP
In both cases, an increase in LRAS means that there is an increase in potential real GDP or full
employment output, from Yf1 to Yf2
LRAS and long run economic growth
Some factors that can cause an increase in LRAS (not an exhaustive list) are:
• An increase in the quantity and/or quality of capital
• An increase in the size of the labour force
• An increase in labour productivity
• Increased (geographic/occupational) mobility of the workforce
• An increase in land (new natural resources)
• Technological progress
• More favourable attitudes to enterprise (increase in the number of risk-taking
entrepreneurs)
• Better institutional structure (improved financial services sector, business-friendly
government policies, improved infrastructure)
A closer look at some key terms
1. Productivity
This refers to the output per unit of factor input in a given period of time. For example,
an increase in labour productivity means that output per worker per year has increased.
An improvement in the quality of capital will often lead to an increase in labour
productivity as workers have better capital with which to work.
2. Infrastructure
This is the large-scale physical capital that is necessary for economic activity to take
place.
Examples: roads, railways, energy supply networks, ports and airports and
telecommunications. The majority of large-scale capital for infrastructure is provided /
funded by the government.
3. Institutions
This refers to the established system of rules which facilitate socio-economic
interactions.
A highly effective institutional structure is characterised by
•
•
•
•
•
a stable and democratic political system
a well-functioning legal system and judiciary, including the protection of property rights
effective and efficient financial system
free press
a developed welfare system (including universal access to education and health care) that
protects the most vulnerable in society
With effective institutions, private owners of capital are more likely to undertake
investment, while entrepreneurs are more likely to take risks and re-invest profits. This
will lead to an increase in the productive capacity of the economy over time.
Anderton p212: Comparing UK living standards over time
1. First we need to calculate Real GDP in 2013 measured in 1971 prices.
Recall that Real GDP = (Nominal GDP/ GDP deflator) x 100
Real GDP in 2013 = (1713.3/1136.3) x 100 = £150.78 billion
Real GDP per capita in 2013 = £(150,780m/64.2m) = £2348.60 (at 1971 prices)
Real GDP per capita in 1971 was £(60,900m/55.5m) = £1097.30
Therefore, real GDP per capita in 2013 was (2348.6/1097.3=) 2.14 times higher than in
1971.
Anderton p212
2. a) Better off: higher GDP per capita, higher percentage of households owning domestic
appliances, higher life expectancy, greater home ownership, greater number of people going to
university, more women working, fewer people smoking. In each case, explain why this means
people are ‘better off’ and remember to quote specific figures from the data in your answer
b) Worse off: increase in percentage of obese people, much greater volume of traffic (longer
journey times), mortgage payments are a larger fraction of income for first time buyers (harder
to get on property ladder). Again, refer to specific figures.
3. From question 2a, we can see that the increase in per capita real GDP between 1971 and 2013
was accompanied by a rise in many other indicators of living standards. However, we have also
seen in 2b that people were worse off when it came to other indicators.
Furthermore, the data does not tell us anything about the distribution of income; therefore, we
cannot say whether ‘everyone’ in the UK was better off. It is likely that the doubling of real GDP
per capita raised living standards on average, but we do not know how indicators like long-term
unemployment, health problems and home (and wealth) ownership changed for different parts
of the population during these decades.
Consequences of economic growth
Introduction
Recall that one of the policy objectives of the government is positive and stable
economic growth.
In the short run, this means minimising the effect of fluctuations in economic
activity and it usually involves demand management (stabilising) policies.
In the long run, the goal is to achieve sustained and sustainable economic
growth, which requires supply-side policies.
Benefits of economic growth
1. Higher employment: Economic growth will lead to an increase in employment as
firms demand more labour to produce more goods and services. Incomes of
households will increase, while costs associated with unemployment are likely to
fall.
2. Higher living standards: Economic growth leads to increased employment and
higher incomes for households. This means that they can afford to increase
consumption of goods and services. If there is an increase in per capita real GDP,
then we can say that economic growth leads to higher standards of living.
3. Increasing tax revenue: Economic growth has a positive effect on government
finances; there will be higher (income and corporation) tax revenues while benefit
payments are likely to fall. If this additional sum is spent on services like health and
education or on infrastructure projects, then this could further increase potential
output.
Benefits of economic growth
4. Multiplier and accelerator effects: Economic growth encourages investment in
capital by firms (accelerator) and the increased investment can lead to further
multiplier effects on national income. If increased investment increases the quantity
and/or quality of capital, this will increase long run aggregate supply and further
enhance growth.
5. Increased business confidence: Economic growth normally has a positive impact on
company profits and business confidence. It has a positive impact on the stock
market (assets values increase, thus increasing wealth) and could encourage
entrepreneurship and growth of businesses.
6. Greater opportunity for the government to redistribute income: Since government
finances are likely to improve with economic growth, the government can focus on
transfer payments and policies to reduce poverty and inequality.
Costs of economic growth
1. Growth might become unsustainable, meaning that current growth in the productive
capacity of the economy leads to a fall in the potential output of the economy for future
generations. For example, there is the danger of exhausting non-renewable resources such as oil
or minerals, over-grazing, over-fishing and greater pollution. To avoid this, we need to look for
alternative renewable resources and have stricter regulations on pollution.
2. Rising income and wealth inequality: The benefits of economic growth tend to accrue to
those at the top of the income distribution and this may carry on into future generations
(through inheritance and better opportunities). Despite high growth rates of GDP, some people
in developing countries live in absolute poverty, whereas some in developed economies live in
the relative poverty (more on this later).
3. Growth and happiness: Research shows that happiness and income are positively related at
low levels of income, but once basic needs are met, increasing the quantity of goods consumed
does not make any difference to happiness and well-being (Easterlin paradox).
Some interesting video links
Global Wealth Inequality - What you never knew you never knew (See
description for 2017 updates) – YouTube
World Inequality Report 2018 - YouTube
How climate change is making inequality worse, especially for children - BBC
News
Benefits and Costs of Economic Growth (2019 Update) | tutor2u