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Economic Growth

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Economic Growth

The UK’s population grew from barely 56 million in 1970 to over 67 million in 2020. This is a growth of over 11 million in only 50 years! With that amount of people in the country, sustainable economic growth is important. Let’s study what economic growth is, its causes, benefits, and costs.

Economic growth is an increase in the potential level of real output an economy can produce in a specified period (typically one year).

Types of economic growth

There are two types of economic growth: short-run and long-run economic growth.

Short-run economic growth

Short-run economic growth occurs when the economy uses spare capacity in order to increase the real output.

Aggregate supply (AS) is the total value of goods and services produced in the economy over a particular time. Whereas aggregate demand (AD) is the total amount of money spent on goods and services produced in the economy over a particular time.

Figure 1 shows the movements of real GDP (Y) and price level (P) when the aggregate demand (AD) increases.

Economic Growth Short-run economic growth StudySmarterFigure 1. Short-Run Economic Growth, StudySmarter Original

When AD increases (from AD1 to AD2), the real GDP increases (from Y1 to Y2) causing a significant rise in the price level (from P1 to P2).

SRAS stands for short-run aggregate supply.

Long-run economic growth

Long-run economic growth is an increase in the productive capacity of the economy due to an increase in the long-run aggregate supply.

It means that the potential or trend economic growth rate is higher.

Trend growth rate or potential growth rate is a rate at which output can grow sustainably over a period of time.

Figure 2 shows the movements of real GDP (Y) and price level (P) when LRAS increases.

Economic Growth Long-run economic growth StudySmarterFigure 2. Long-Run Economic Growth, StudySmarter Original

When LRAS increases, the real GDP increases (from Y1 to Y2), causing a significant fall in price level (from P1 to P2).

LRAS stands for long-run aggregate supply.

It is also worth looking at a PPF diagram.

economic growth ppf studysmarterFigure 3. Economic Growth PPF, StudySmarter Original

Short-run economic growth is a movement from inside PPF1 to a point on PPF1 (A to B). Long-run economic growth is an outward shift of PPF (B to C). The inward shift of the PPF is similar to the LRAS curve shifting to the left. The outward shift of the PPF is similar to the LRAS curve shifting to the right.

PPF stands for production possibility frontier.

To learn more about the PPF check out our explanation on Production Possibility Curves.

Causes of short-run and long-run growth

Both short-run and long-run economic growth have their causes. Table 1 presents the causes of short-run and long-run economic growth.

Short-run economic growthLong-run economic growth
Higher income Increase in the size of the workforce
Lower corporation taxNew resources
Higher government spendingIncreased investment
Weaker exchange rateIncrease in labour productivity
Lower interest ratesTechnical progress

Table 1. Causes of short-run and long-run economic growth - StudySmarter.

Shifts of aggregate demand and aggregate supply and economic growth

Let’s study how the shifts of the aggregate demand and supply are related to economic growth.

Shifts of aggregate demand

Changes in aggregate demand relate to a demand-side influence on an economy. This means that any changes in the components of aggregate demand cause a shift in the position of the AD curve.

AD = C + I + G + (X-M)

If there is an increase in consumption, investment, government spending, or net export demand, the AD curve shifts to the right (see figure 4).

Economic growth Shifts of aggregate demand StudySmarterFigure 4. Shifts of Aggregate Demand, StudySmarter Original

What happens next depends on the aggregate supply curve. You can see the SRAS (short-run aggregate supply) curve moving from very low to very high levels of real income crossing a vertical LRAS curve.

When a level of real output is below the full capacity level of output (Y5), AD shifts from AD1 to AD2 increasing the real output (Y1 to Y2), but not the price level (P1). A reason for that is the spare capacity in an economy. When an economy has plenty of spare capacity the aggregate demand can increase without creating inflationary pressures.

Full capacity occurs when an economy’s growth rate is equal to the potential or trend growth rate.

Spare capacity occurs when an economy’s growth rate is less than the potential or trend growth rate.

Nevertheless, when output increases, the SRAS curve gradually slopes upwards. Now both aggregate demand and prices increase (AD3 to AD4 and P2 to P3) causing higher rates of inflation.

When the economy is at full capacity (on the LRAS curve at Y5), an increase in aggregate demand will be purely inflationary.

Shifts of aggregate supply

Changes in aggregate supply relate to a supply-side influence on an economy. If real output reaches its full capacity, long-run economic growth requires the LRAS curve to shift to the right like in figure 5.

Economic growth Shifts of aggregate supply StudySmarterFigure 5. Shifts of Aggregate Supply, StudySmarter Original

The long-run aggregate supply moves from LRAS1 to LRAS2 causing the level of output to move from Y1 to Y2.

Long-run economic growth allows an economy to grow sustainably. A rate at which output can grow sustainably is the trend growth rate (or potential growth rate).

Benefits and costs of economic growth

Although economic growth seems to be entirely positive, it has both benefits and costs. Let’s see the main ones.

BenefitsCosts
Increased standards of livingSocial inequalities
Technology developmentEnvironmental pollution
Poverty reductionUsing up of finite resources
Higher tax revenuesHigh urbanisation
Increased investmentsHigh inflation

Sustainable economic growth

Economic growth is often associated with the excessive use of natural resources that are non-renewable. Moreover, economic growth tends to contribute to environmental pollution which is caused by increased output and waste.

Economic growth is also associated with sharp price increases and imbalances in terms of labour exploitation and social inequalities. That is why to maximise the benefits and reduce the costs of economic growth, it needs to be sustainable.

Sustainable economic growth is growth that can be maintained in the long term.

Sustainable economic growth includes two main elements:

  • Environment: sustaining natural resources and protecting the environment.
  • Economy: keeping inflation low and finding a balance between the different forces and pressures.

Economic Growth - Key takeaways

  • Economic growth is an increase in the potential level of real output an economy can produce in a specified period of time (typically one year).
  • Short-run economic growth is when the economy uses spare capacity in order to increase the real output.
  • Long-run economic growth is an increase in long-run aggregate supply. It is when there is an increase in the productive capacity of the economy.
  • Sustainable economic growth is growth that can be maintained in the long term.

Frequently Asked Questions about Economic Growth

Economic growth is an increase in the potential level of real output an economy can produce in a specified period of time (typically one year).

Short-run and long-run economic growth.

Short-run economic growth is an increase in aggregate demand, whereas long-run economic growth is an increase in long run aggregate supply.

- Higher income

- Increase in size of workforce

- Lower corporation tax

- New resources

- Higher government spending

- Increased investment

- Weaker exchange rate

- Increase in labour productivity

- Lower interest rates

- Technical progress

Final Economic Growth Quiz

Question

For economic growth to be sustainable, it should be:

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Answer

slow

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Question

What is a full capacity?

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Answer

Full capacity occurs when an economy is making full use of its available capacity.

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Question

What is a spare capacity?

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Answer

Spare capacity occurs when an economy is not making full use of its available capacity.

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Question

Give two examples of benefits of economic growth.

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Answer

Any two of:

  • Increased standards of living
  • Technology development
  • Poverty reduction
  • Higher tax revenues
  • Increased investments

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Question

Give two examples of costs of economic growth.

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Answer

Any two of:

  • Social inequalities
  • Environmental pollution
  • Using up of finite resources
  • High urbanisation
  • High inflation

Show question

Question

Define economic growth.

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Answer

Economic growth is an increase in the potential level of real output an economy can produce in a specified period of time (typically one year).

Show question

Question

What is short-run economic growth?

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Answer

Short-run economic growth is an increase in aggregate demand. It is when the economy uses spare capacity in order to increase the real output.

Show question

Question

What is the difference between aggregate supply and aggregate demand?

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Answer

Aggregate supply (AS) is the total value of goods and services produced in the economy over a particular time. Aggregate demand (AD) is the total amount of money spent on goods and services produced in the economy over a particular time. 

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Question

What is long-run economic growth?

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Answer

Long-run economic growth is an increase in the productive capacity of the economy due to an increase in the long-run aggregate supply.

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Question

What does PPF stand for?

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Answer

Production possibility frontier

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Question

What happens to the price level in the long-run economic growth?

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Answer

The price level falls.

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Question

What happens to the price level in the short-run economic growth?

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Answer

The price level increases.

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Question

What are the causes of short-run economic growth?

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Answer

  • Higher income
  • Lower corporation tax
  • Higher government spending
  • Weaker exchange rate
  • Lower interest rates

Show question

Question

What are the causes of long-run economic growth?

Show answer

Answer

  • Increase in size of workforce
  • New resources
  • Increased investment
  • Increase in labour productivity
  • Technical progress

Show question

Question

Changes in aggregate demand relate to...


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Answer

a demand-side influence on an economy.

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