3.3.2 Economic Growth

• Economic growth can occur in the short-term or long-term and each is explained differently
   
• Changes to any of the components of aggregate demand (AD) will cause short-term economic growth to occur
  • This is illustrated on an AD/AS diagram by a rightward shift in AD
  • It can also be illustrated by using the production possibilities curves model by moving from a point inside the curve to a point closer to the curve
     

1. Short-term Economic Growth on an AD/AS Diagram
 

Short-term economic growth through a shift of aggregate demand from AD→AD₁
 

Diagram Analysis

• An increase in consumption, investment, government spending or net exports has caused a shift in AD from AD→AD₁
• The current real output has increased from Y₁→Y₂ which represents an increase in real GDP
  • An increase in real GDP = economic growth
• This short-term growth has led to an increase in average prices from AP₁→AP₂
   

2. Short-term Economic Growth on a Production Possibilities Curve (PPC)
  

Short-term economic growth on a production possibilities curve (PPC) model

 
Diagram Analysis

• An increase in production has caused a shift in production combinations from X→Y
• The current real output has increased moving closer to the maximum possible output of the economy
  •  This represents an increase in real GDP
  • An increase in real GDP = economic growth
    

• Long-term economic growth is caused by any improvements to the determinants of long-run aggregate supply
  • This is illustrated on an AD/AS diagram by a rightward shift in the LRAS
  • It can also be illustrated using the PPC model through a shift outwards of the entire curve
      

1. Long-term Economic Growth on an AD/AS Diagram
  

Long-term economic growth through an increase in the long-run aggregate supply (LRAS) of the economy 

 

Diagram Analysis

• A change to the quantity/quality of the factors of production has increased potential output of the economy from Y_FE→Y_FE1
  • E.g. More rigorous competition policy creates a higher number of firms in each industry leading to greater aggregate supply in the economy
    • This shifts the long-run aggregate supply curve to the right LRAS₁→LRAS₂ resulting in economic growth
      
• The final impact on price levels depends on the shape of the long-run aggregate supply curve (Keynesian or Classical)

 

2. Long-term Economic Growth Using a PPC Model
 

• The entire PPC of an economy can shift inwards or outwards thereby changing its production possibilities
• An outward shift demonstrates long-term economic growth
   

Outward shifts of a PPC show long-run economic growth

 

Diagram Explanation

• Economic growth occurs when there is an increase in the productive potential of an economy
  • This is demonstrated by an outward shift of the entire curve
  • More consumer goods and more capital goods can now be produced using all of the available resources
     
• This shift is caused by an increase in the quality or quantity of the available factors of production
  • One example of how the quality of a factor of production can be improved is through the impact of training and education on labour. An educated workforce is a more productive workforce and the production possibilities increase
  • One example of how the quantity of a factor of production can be increased is through a change in migration policies. If an economy allows more foreign workers to work productively in the economy, then the production possibilities increase

• Economic growth is measured by calculating the change in the real GDP between two time periods (usually quarterly or annually)
• The growth rate is expressed as a percentage
• Several steps can be included in the calculation of an economic growth rate

1. Calculate nominal GDP from a set of data for two time periods
2. Calculate the real GDP for each time period using the GDP deflator
3. Calculate the percentage change in real GDP between the two time periods

Worked Example

Step 1:  Determine which of the data presented is relevant to the calculation

Nominal GDP = C + I = G = (X-M)

So income tax and net income are not relevant

Step 2: Substitute the relevant values into the GDP formula for 2018

Nominal GDP 2018  = C + I + G + (X-M)

Nominal GDP 2018  = 11255  + 8927 + 15697 + (8532 - 4957)

Nominal GDP 2018 = $39,454 billion

Step 3: Substitute the relevant values into the GDP formula for 2019

Nominal GDP 2019  = 11945  + 11100 + 16500 + (10300 - 3988)

Nominal GDP 2019 = $45,857 billion
 

Step 4: Calculate the real GDP for each year using the GDP deflator

 

Step 5: Calculate the real economic growth rate (the % change in real GDP)

     

 
(4 Marks for the correct answer or one mark for any correct work in the process. Final answer must be rounded to 2 decimal places)

Exam Tip

• Economic growth is considered to be the main contributor to an improvement in the standards of living
• Due to the negative aspects of economic growth, there is much controversy about maintaining it as a central macroeconomic aim
  • Instead, arguments for a focus on societal well-being are gaining traction
    
    

An Evaluation of Economic Growth

Impact	Benefits of Economic Growth	Costs of Economic Growth
Living standards	Increased incomes lead to better standards of living Increased employment resolves some of the negative social impacts of unemployment	Rising aggregate demand causes demand pull inflation and the purchasing power of people on fixed incomes may fall Increased income usually leads to greater consumption of demerit goods Greater output often requires more time from workers and can decrease leisure time and well-being
The Environment	Improvement in the quality/quantity of environmentally friendly technologies	Environmental damage caused by negative externalities of production and consumption increases Resources are depleted more rapidly
Income distribution	Decreased levels of absolute poverty Higher levels of employment mean that there is more tax revenue for governments to redistribute on welfare payments	Lack of equity in the distribution of income - the rich may get richer and the poor poorer

Exam Tip