Economics | Economic growth

Welcome to Economic Growth!

Hi everyone! Economic growth is perhaps the most important concept in all of macroeconomics. Why? Because nearly every policy goal a government has—from reducing poverty to improving healthcare—depends on a growing economy.

Don't worry if this chapter seems tricky at first. We will break down how growth is defined, measured, and what causes it, using clear steps and real-world examples. Let’s get started!

Chapter Focus: Economic Growth (Macroeconomic Performance)

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1. Defining and Visualising Economic Growth

1.1 What is Economic Growth?

In simple terms, economic growth is an increase in the amount of goods and services produced in an economy over a period of time.

There are two crucial types of growth you must understand:

• Actual Economic Growth: This is the short-run increase in real output (Real GDP). It means the economy is currently using its existing resources more effectively.
• Potential Economic Growth: This is the long-run increase in the productive capacity of the economy. It means the maximum possible output the economy can produce has increased.

Analogy: Imagine you run a small bakery. Actual growth is selling more cakes this month than last month using the oven you already have. Potential growth is buying a bigger, faster oven, allowing you to produce double the cakes in the future.

Key Term: The Economic Cycle

Actual growth is closely tied to the economic cycle (or trade cycle). Economies move through periods of boom (rapid actual growth), slowdown, recession (negative actual growth), and recovery.

1.2 Visualising Growth: The Production Possibility Curve (PPC)

The PPC is a great tool for understanding the difference between actual and potential growth.

A. Actual Growth (Short-Run):

• This is represented by a movement from a point inside the PPC boundary towards the boundary itself.
• It signifies a reduction in spare capacity (unemployed resources are being used).

B. Potential Growth (Long-Run):

• This is represented by an outward shift of the entire PPC curve.
• It signifies an increase in the economy’s total capacity due to improvements in the quantity or quality of factors of production.

Memory Trick (PPC):
PPC = Possible Production Capacity. If the line shifts out, capacity has increased!

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2. Measuring Economic Growth

To measure economic growth, we primarily look at the change in National Income statistics. The main measure is Gross Domestic Product (GDP).

2.1 Gross Domestic Product (GDP)

GDP measures the total monetary value of all final goods and services produced within a country's borders in a specific time period (usually one year).

Why is Real GDP Important?

When measuring growth, we must adjust for inflation. If output rises by 5% but prices (inflation) rise by 5%, your actual standard of living hasn't improved.

• Nominal GDP: GDP measured at current prices. (This includes the effect of inflation.)
• Real GDP: GDP measured after accounting for inflation (i.e., measured at constant prices).

We always use Real GDP to measure actual economic growth.

2.2 GDP Per Capita

A country might have a huge GDP, but if it also has a massive population, the average person may still be poor. To get a better idea of individual living standards, economists use GDP per capita:

$$ \text{GDP per capita} = \frac{\text{Total Real GDP}}{\text{Population}} $$

Example: If Country A has a GDP of $1 trillion and a population of 10 million, and Country B has a GDP of $500 billion and a population of 1 million, Country B likely has higher average living standards because its GDP per capita is higher.

2.3 Gross National Income (GNI)

While GDP focuses on production within a country’s borders, GNI (formerly GNP) includes the income earned by citizens and companies abroad, minus the income earned by foreigners in that country.

GNI is often a better measure of the national income available to the citizens of a country.

Did You Know?

When comparing countries, economists often use Purchasing Power Parity (PPP) adjusted GDP. PPP attempts to adjust exchange rates so that an identical basket of goods costs the same in different countries, giving a more accurate comparison of living standards.

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3. Causes and Determinants of Economic Growth

Growth can be driven by increases in Aggregate Demand (AD) in the short run, or increases in Aggregate Supply (AS) in the long run.

3.1 Short-Run Growth (Driven by AD)

Short-run growth occurs when there is an increase in any of the components of Aggregate Demand: \(AD = C + I + G + (X - M)\). This moves the economy closer to its existing productive capacity.

Key drivers of AD growth include:

• Consumer Spending (C): Lower interest rates encourage borrowing and spending.
• Investment (I): Increased business confidence leads firms to invest in new machinery.
• Government Spending (G): Increased spending on infrastructure or public services.
• Net Exports (X-M): A weakening currency (depreciation) makes exports cheaper.

3.2 Long-Run Growth (Potential Growth – Driven by AS)

Long-run growth requires an increase in the economy’s overall productive capacity, meaning the Long Run Aggregate Supply (LRAS) curve shifts to the right. This happens when the quantity or quality of the factors of production improves.

A. Labour (The Workforce)

• Quantity: An increase in population, net migration, or higher retirement age.
• Quality: Improvements in education and training (increasing human capital) leading to higher productivity.

B. Capital (Physical and Human)

• Investment: New machinery, factories, and infrastructure (e.g., better roads, faster internet) that boost production efficiency.
• Infrastructure Spending: Government spending that reduces costs for businesses (e.g., efficient ports).

C. Natural Resources (Land)

• Quantity: Discovery of new resources (e.g., oil, gas).
• Quality: Better land management techniques or improved recycling methods.

D. Technology and Enterprise

• Innovation: Technological advancements (new production methods, AI) allow more output from the same inputs.
• Enterprise: A regulatory environment that encourages risk-taking, new business formation, and competition.

Key Takeaway: Sustained, long-term improvement in living standards relies entirely on increasing Potential Growth (LRAS shifts).

3.3 Growth Visualised on the AD/AS Diagram

1. Short-Run Growth: AD shifts right (e.g., \(AD_1\) to \(AD_2\)) along a fixed LRAS curve. Output rises from \(Y_1\) to \(Y_2\).

2. Long-Run Growth: The LRAS curve shifts right (e.g., \(LRAS_1\) to \(LRAS_2\)). The maximum sustainable output of the economy increases.

To achieve both low inflation and high growth, policymakers aim to increase both AD and LRAS simultaneously, ideally with the LRAS shift being stronger.

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4. The Benefits of Economic Growth

High rates of economic growth are desirable because they bring numerous benefits to an economy:

4.1 Improved Living Standards

• Higher Income: Increased real GDP per capita means people, on average, have more disposable income to spend on goods and services.
• Reduced Poverty: Growth often "lifts all boats," helping the poorest groups by providing more jobs and higher wages.

4.2 Improved Public Finances

When the economy grows:

• Tax Revenue Rises: More people are working (income tax) and spending (sales tax), increasing government revenue.
• Government Spending Falls: Less need to spend on welfare benefits (unemployment support) as jobs are created.
• This often leads to a smaller budget deficit or larger budget surplus.

4.3 Increased Investment

High growth stimulates business confidence, leading to:

• The Accelerator Effect: High demand requires firms to expand capacity, increasing investment (I). This also helps future potential growth.
• Technological Progress: Increased profits allow firms to fund research and development (R&D).

4.4 Wider Social Benefits

Wealthier countries can afford to improve infrastructure, public services, and environmental protection (e.g., better schools, hospitals, and parks).

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5. The Costs of Economic Growth

Economic growth is not without its trade-offs. Policy-makers must manage these potential costs.

5.1 Environmental Costs

• Resource Depletion: Rapid growth requires more raw materials, potentially depleting finite resources.
• Pollution and Climate Change: Increased production often leads to higher emissions (carbon, waste), damaging the environment.

Common Mistake to Avoid: Don't just say 'pollution'. Explain why growth causes it (increased industrial activity, transport, and consumption).

5.2 Inflation

If actual growth is driven primarily by Aggregate Demand (AD) shifting right faster than Long Run Aggregate Supply (LRAS), the economy overheats, leading to demand-pull inflation.

5.3 Inequality and Distribution

Often, the benefits of growth are not distributed evenly.

• The owners of capital and highly skilled workers may see their incomes rise significantly faster than low-skilled workers.
• This can increase the gap between the rich and the poor, leading to social and political tension.

5.4 External Costs and Quality of Life

• Congestion: Higher economic activity often means more cars, more traffic, and stressed infrastructure.
• Loss of Leisure Time: High growth periods may encourage longer working hours, reducing workers' leisure time and overall well-being.

Congratulations! You have covered the essential components of economic growth. Make sure you can draw and explain the PPC and AD/AS diagrams associated with both actual and potential growth.