3.5 - Economic Growth

The definition of economic growth

Economic growth describes an increase in an economy's real gross domestic product (GDP) through time. Real GDP accounts for inflation, so the rise it records is a genuine increase in output rather than higher prices.

Measuring economic growth

Economic growth is quantified using the growth rate, which shows the percentage change in real GDP over time. This can be between years or quarters, and it may also use per capita real GDP to account for population changes.

Formula for calculating the growth rate

$$\text{Growth rate}=\frac{{\text{rGDP}}_{\text{year 2 }}-{\text{ rGDP}}_{\text{year 1}}}{{\text{rGDP}}_{\text{year 1}}}\times 100$$

Where:

• rGDP_{year 2} = Real GDP in the later year
• rGDP_{year 1} = Real GDP in the earlier year

A negative growth rate signals a recession, where real GDP falls. A positive but declining growth rate indicates the economy is expanding, though at a reduced pace.

Worked example - Calculating the growth rate

In 2021, an economy's real GDP was £2,500 billion. In 2022, it rose to £2,650 billion. Calculate the growth rate from 2021 to 2022.

Step 1: Identify the values

• rGDP₂₀₂₁ = £2,500 billion
• rGDP₂₀₂₂ = £2,650 billion

Step 2: Apply the growth rate formula

$$\text{Growth rate}=\frac{\pounds \mathrm{2,650}-\pounds \mathrm{2,500}}{\pounds \mathrm{2,500}}\times 100$$

Step 3: Calculate the growth rate

$$\text{Growth rate}=\frac{\pounds 150}{\pounds \mathrm{2,500}}\times 100=6\%$$

Short-term economic growth and its factors

Short-term economic growth arises from making better use of an economy's current resources, without altering its maximum potential output. It occurs when aggregate demand rises, shifting the aggregate demand (AD) curve rightwards from AD₁ to AD₂ along the aggregate supply (AS) curve. This can stem from boosts in any AD component: consumption (C), investment (I), government spending (G), or net exports (NX).

The diagram below uses the Keynesian AS curve, which is flat while the economy still has spare capacity. Real output rises from Yr₁ to Yr₂ and the average price level (APL) stays at APL₁, because firms can meet the extra demand without bidding up their costs.

Factors that lead to short-term growth

Long-term economic growth and its factors

Long-term economic growth stems from enhancements in the quantity or quality of resources, or from technological progress, which raise an economy's potential output. This shifts the long-run aggregate supply (LRAS) curve rightwards, allowing sustained increases in real GDP.

The diagram below shows the Monetarist/New Classical version. The curve shifts right from LRAS to LRAS₁, so potential output rises from Yp to Yp₁. Aggregate demand (AD) is unchanged, so the extra capacity also pulls the average price level down from APL₁ to APL₂.

Factors that lead to long-term growth

Illustrating economic growth and dual impacts

Economic growth can be shown using models like AD/AS diagrams or production possibility curves (PPC). These illustrate how short-term and long-term growth differ, while some factors influence both.

Illustrating short-term growth

In AD/AS models - A rightward shift in the AD curve raises real output. In Keynesian views, this may not increase prices if the economy has spare capacity. In Monetarist or New Classical views the starting point decides the outcome, as the diagram below shows. The original equilibrium sits to the left of potential output Yp, so the shift from AD₁ to AD₂ along the short-run aggregate supply (SRAS) curve raises real output from Yr₁ to Yr₂, though the average price level also rises from APL₁ to APL₂. Had the economy already been at Yp on the long-run aggregate supply (LRAS) curve, the extra demand would have lifted the price level and nothing else.

In PPC diagrams - The economy moves from a point inside the curve towards its boundary, producing more without shifting the curve itself. In the diagram below the economy starts at F and moves to H: output of good X rises from X₁ to X₂ and output of good Z from Z₁ to Z₂, while the PPC itself does not move.

Illustrating long-term growth

In AD/AS models - A rightward shift in the aggregate supply (AS) or LRAS curve raises what the economy is able to produce. The diagram below shows the Keynesian case: AS shifts right to AS₁, so full employment output rises from Yf to Yf₁, and because aggregate demand (AD) has not moved the average price level eases from APL₁ to APL₂ rather than rising.

In PPC diagrams - The entire curve shifts outwards, showing greater production possibilities for all goods. In the diagram below the frontier moves out from PPC to PPC₁, so the economy can now produce more of good X and more of good Z than before.

Dual impacts of certain factors

Some elements affect both short-term and long-term growth: