Economic Growth

Economic growth means an increase in real GDP – which means an increase in the value of national output/national expenditure.

Economic growth is an important macro-economic objective because it enables increased living standards, improved tax revenues and helps to create new jobs.

real-gdp-1955
UK real GDP since 1955. Showing sustained a rise in national output (despite brief periods of negative economic growth).

Source: ONS

 

Causes of economic growth

Economic growth is caused by rising demand and an increase in productive capacity.

  1. An increase in aggregate demand AD=(C+I+G+X-M) – a rise in consumption, investment, government spending, exports – imports.
  2. Increase in aggregate supply (increase in capital, investment, higher labour productivity)

Diagram showing long run economic growth

asad

In this diagram, we have an increase in aggregate demand (AD) and an increase in long run aggregate supply (LRAS). This enables a rise in real GDP – without causing inflation.

Example of economic growth

  • If the Central Bank cut interest rates, this would provide an incentive for firms to invest (borrowing would now be cheaper).
  • This investment is a component of AD and AD will rise. WIth higher investment, more people will be employed, and there is a purchase of raw materials.
  • Also, the cut in interest rates will encourage consumer spending due to lower borrowing costs and lower mortgage repayments. This will cause an additional rise in AD.
  • The investment will also lead to an increase in productive capacity (LRAS) with firms gaining more capacity to meet demand.

Productivity

  • A key factor in enabling economic growth in the long-term is productivity. Productivity is output per worker.
  • If there is the development of new technology (computers, machines), it means workers will be able to do produce more.
  • This growth in output per worker is a key factor behind economic growth.

Policies to increase economic growth

  1. Supply Side Policies – government attempts to increase productivity and increase efficiency in the economy. The aim is to shift LRAS to the right. Examples could include:
    • Income tax cuts (to increase incentives to work);
    • Privatisation (Make government owned firms private to increase the profit-incentive and efficiency.)
    • Reduce red-tape and bureaucracy which raises costs for firms.
    • Spending on education and training to improve labour productivity
  2. Monetary policy – Reducing interest rates to stimulate economic activity and increase AD.
  3. Fiscal policy – Higher government spending and/or cutting taxes to boost aggregate demand

Benefits of economic growth

  1. Higher incomes for workers and firms.
  2. Increased tax revenue for the government which can be spent on public services, e.g. education, pensions and health care. Higher economic growth usually reduces the government’s budget deficit.
  3. Helps create employment and reduce unemployment.
  4. See: Benefits of economic growth

 Potential costs of economic growth

  1. Inflation. If growth is too fast, we could experience inflation.
  2. Current account deficit. If growth is unbalanced, we could see a growing current account deficit as people buy more imports.
  3. Environmental costs. Economic growth leads to higher resource consumption and pollution.
  4. See more at: Costs of Economic Growth

Long run trend rate of economic growth

real-gdp-trend-actual

The long run trend rate is the average sustainable rate of growth over a period of time. The long run trend rate depends on the growth of productivity and is related to levels of technology and investment.

Other Definitions

  • Balanced growth – growth that is sustainable (avoiding booms and busts)
  • Trade cycle – how economic growth can be cyclical – booms, busts, recovery

Recessions

us-economic-growth

A recession is a period of negative economic growth, where output falls for two consecutive quarters. This graph shows the deep recession in the US economic 2008-09. (known as the Great recession)

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