Economic Growth

P2 - Topic 5

Actual growth

An increase in real GDP: using existing spare capacity (movement towards the PPF)

Potential growth

An increase in productive capacity: outward shift of the PPF / LRAS

Causes of actual growth

A rise in any AD component (C, I, G, X − M)

Export-led growth

Growth driven by rising exports. Raises AD, and the large export market allows economies of scale (e.g. China, South Korea)

Causes of potential growth

Domestic investment and FDI, innovation, a growing labour force (incl. net migration), more competition

Investment and FDI and growth

Raise the capital stock and bring technology, so both AD and LRAS rise

Innovation and growth

New products and processes raise productivity, so LRAS shifts right

Labour force and growth

More workers (births, participation, migration) raise potential output, though not necessarily output per head

Competition and growth

Forces firms to cut costs and innovate, raising efficiency

Productivity and growth

The key long-run driver: more output per worker raises potential output and living standards without needing more inputs

Trend growth rate

The average long-run rate at which potential output grows

Benefits of growth

Higher living standards, lower unemployment, higher profits, more investment, more tax revenue, better public services

Growth and tax revenue

Higher incomes and spending raise tax receipts without higher tax rates, funding public services or cutting the deficit

Costs of growth

Opportunity cost, environmental damage, trade deficits, greater inequality, inflation

Opportunity cost of growth

More investment now means less consumption now

Environmental cost of growth

More pollution, resource depletion and carbon emissions. May be unsustainable

Growth and the trade balance

Rising incomes suck in imports, so the trade balance worsens

Growth and inequality

Gains may go mainly to owners of capital and the skilled

Growth and inflation

If AD grows faster than capacity, demand-pull inflation results

Output gap

Difference between actual output and potential (trend) output

Positive output gap

Actual output above potential: overheating

Characteristics of a positive gap

Low unemployment, labour shortages, rising inflation, current account worsening

Negative output gap

Actual output below potential: spare capacity

Characteristics of a negative gap

High unemployment, unused capacity, low or falling inflation

Difficulties of measuring output gaps

Potential output cannot be observed. Data is revised. Trend estimates differ. Spare capacity is hidden (e.g. underemployment)