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 definition

Economic growth definition 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 two types of economic growth are:

• short-run economic growth
• long-run economic growth.

Short run economic growth

Short run economic growth is when the economy uses spare capacity in order to increase the real output. Spare capacity occurs when there is an under-utilisation of the economy's productive potential. In other words, either not all resources are utilised, or they are not utilised efficiently. Figure 1 shows the short run economic growth by the movements of real GDP (Y) and the price level (P) when the aggregate demand (AD) increases.

Fig. 1 - Short-Run Economic Growth

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).

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.

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. Figure 2 shows the long run economic growth by the movements of real GDP (Y) and the price level (P).

Fig. 2 - Long-Run Economic Growth

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

It is also worth looking at a PPF diagram.

Fig. 3 - Economic Growth PPF

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.

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.

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).

Fig. 4 - Shifts of Aggregate Demand

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.

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.

Fig. 5 - Shifts of Aggregate Supply

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.

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 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.