Economic Growth

A-level Economics

understanding how economies grow. how to achieve it. advantages and disadvantages.

Economic growth can be defined in the short-run or long-run. Short-run economic growth occurs when there is a rise in gross domestic product. Long-run economic growth occurs when there is an increase in productive capacity.

Short-run economic growth is likely to fluctuate up and down in what is known as the economic cycle. Short-run economic growth is caused by increases in AD and increases in SRAS.  Some things that cause short-run economic growth to happen: increase in spending, injections, decreases in production costs.

Long-run economic growth is not as likely to fluctuate up and down like short-run growth is. It is also known as potential growth. It is the growth of our supply-side and therefore our potential to supply. Some things that cause long-run economic growth: investment into more advanced machinery, training the labour force, improvements in the education system and technology.

Short-run vs Long-run Economic Growth - Diagrams

Economic Cycle

The economic cycle represents how an economy grows over time. We divide growth into two forms, actual and trend growth.

When actual growth is sloping upwards, it means short-run economic growth is occuring. The economy's GDP growth is positive.

When actual growth is sloping downwards and continues for two successive quarters, the economy is in a recession.

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Characterisitcs of Boom/Recession Periods

In a boom, spending is high, therefore inflationary pressure is high. Employment will be higher because the demand for labour is a derived demand. GDP growth will be positive and will be growing quickly.

In a boom, there is a positive output gap, when actual gdp exceeds the trend (potential) gdp. (labelled on diagram)

In a recession, spending is low, therefore inflationary pressure is low. There may even be a risk of deflation. Employment will be lower so unemployment will be high. There will be cyclical unemployment. GDP growth will be negative.

In a recession, there is a negative output gap, when actual gdp is smaller than trend (potential) gdp. (labelled on diagram)

Demand vs Supply-side shocks

This will lead to a change in economic growth.

Demand-side shocks are things that cause AD to shift left or right. Some examples include:

1. Global recession -> will cause your country's exports to decrease due to less demand from abroad

2. Housing market boom -> could cause the wealth effect. Can cause increases in spending and confidence.

Supply-side shocks are things that cause AS to change. Some examples include:

1. War -> wars can cause wreckage and destruction everywhere which inhibits the economy's ability to output goods/services

2. Discovery of new resources -> if we discover new resources it means our potential to supply goes up

How does short-run economic growth happen?

Short-run economic growth comes about when AD or SRAS increases. So what does this mean? Anything that is a demand-side factor and anything that cause the cost of production to decrease.

Demand factors could include: lowering of interest rates to stimulate aggregate demand, increases in government spending. These would shift AD to the right

Supply-side factors could include: lowering of wages, lower raw material costs. These would cause competitive firms to decrease their prices and hence short-run output would rise.

Therefore, short-run growth can be shown on a diagram either by AD shifting to the right or SRAS shifting to the right.

How does long-run economic growth happen?

Long-run economic growth comes about when LRAS increases. Things that can affect the LRAS are related to capacity and productivity.

1. Better infrastructure

2. Training schemes

3. Education

4. Technology

5. Innovation

6. New farming methods

7. Investment into capital stock

8. Population growth

Basically, what affects the long-run ability to supply is anything that has an effect on the quantity and quality of the factors of production. Take for example, labour as a factor of production. More labour or better labour could bring about long-run economic growth. Better labour means more productive labour. Labour that can produce more in the same time as before, probably due to increases in training and experience.

What are the constraints on economic growth?

One of the biggest things holding back an economy's ability to grow is the amount of money available in the country. Money has to be available in banks for them to lend to startup businesses. In poorer countries, there is an absence of this finance, and credit often comes at a higher interest rate than in a developed country.

The government can also act as a constraint to a country's economic growth. If a government is corrupt or badly managed, it can lead to a lack of investment from other countries (known as FDI). The government is in charge of managing the country and therefore the economy. If they are mismanaging the economy due to lack of experience or for personal gain, the country's opportunity to grow and develop suffers.

Another constraint could be due to a lack of available space or a lack of population. A country needs the factors of production in order to create outputs. This is why some countries want to attract immigrants in to increase the numbers in the labour force.

Poor levels of infrastructure would also have an effect on a country's ability to grow. Things like phone lines, internet connections, quality of the roads, quality of the healthcare system and schools. If these are in bad condition and not up to date, it can hinder a country's ability to grow further. Again, this would need a government to be managing the economy correctly and for it to spend the taxation revenue on renovation.

What are the advantages of economic growth?

1. Greater income levels for households: with the economy making more and more output, means more and more spending which means more and more income. This is all explained in the circular flow of income model.

2. Greater profits for firms: just like above - more outputs, means more income generated by firms. This could mean higher profits. This can lead to further investment, innovation and invention and increases in employment.

3. Increases in tax revenue: the government benefits from economic growth. They receive more tax and can better afford to fund public services. In a boom period, the government usually operates a budget surplus, because there is less need to spend on welfare payments and at the same time they are receiving greater tax revenues.

4. Greater standards of living: potentially what can happen is that the economy can develop. If the money being made by the economy is being spent in the right way and the government is managing the economy correctly, standards of living and therefore welfare, should be increasing over time.

What are the disadvantages of economic growth?

1. Higher prices: if economic growth grows too fast (demand growing faster than supply), there can be inflationary scares. Firms putting their prices up by too much or too quickly can trigger off the wage-price spiral. This can lead to even more inflation which could turn into hyperinflation. Eventually consumer and business confidence can suffer and this can lead to a recession.

2. Greater income inequality: income inequality can become worse. The people at the top of the corporations can be getting proportionally richer compared to those at the bottom. While the people at the bottom receive increases in wages to keep up with inflation, CEOs and bankers can get huge bonuses when business is doing well.

3. Increased stress: generally, you don't get something for nothing. Economic growth means output is rising, so the stress on factor inputs must also be rising. At work, you may be required to work longer hours or your targets could get out of control and become difficult to manage.

4. Negative externalities: especially to the environment. More output made means more toxic gases in the air. The government must ensure that this is all being taken into account and that our economy does not grow at the expense of our environment/habitat. This is why global warming is such a big issue today.

5. Overuse of finite resources: remember the core part of the economic problem? Our resources are finite. Factor inputs such as oil/coal/gas are finite and will run out one day. If our production gets to a level our resources cannot manage, then it can cause problems for future generations.

Overall, economic growth is a good thing if it is stable. Sustainable economic growth is the key for welfare maximisation and development for the economy over time. Sustainable economic growth means to grow in a way that the economy grows every year without having a negative impact on future generations. We cannot only think of ourselves and our current generation.

For economic growth to be deemed sustainable, a country has to be able to check off all parts of the following checklist:

1. Have you increased your output this year?

2. Do you have a continuous supply of land, labour, capital so your production can continue?

3. Do you have a continually increasing demand for the products being sold in your country?

4. Have you decreased/internalised any negative externalities which bring costs to other parties in the present or in the future?

In reality, it is very difficult to truly answer yes to all of those questions, but countries should work towards this as it improves welfare the present and future.

What have we learned?

1. Definition of economic growth

2. Short-run vs Long-run Growth

3. Economic growth illustrated on 3 different diagrams

4. Economic Cycle

5. Demand and Supply-side shocks

6. Advantages and disadvantages of economic growth

7. Sustainable economic growth