Short-run and long-run economic growth

Economic growth refers to an expansion in an economy's ability to produce goods and services. It can occur over different time periods, with distinct causes and measurements.

Short-run economic growth

Short-run economic growth, also known as actual growth, measures the percentage change in real gross domestic product (GDP) after adjusting for inflation. This type of growth typically results from rises in aggregate demand but can also stem from increases in aggregate supply. It tends to vary, rising and falling over time rather than following a steady path.

Long-run economic growth

Long-run economic growth, or potential growth, arises from enhancements in the economy's overall capacity or productive potential. This usually happens through improvements in the quantity or quality of factors of production, such as advanced machinery or a more skilled workforce.

It is reflected in the trend rate of growth, which is the average growth rate across periods of economic booms and slumps, showing a smooth upward path unlike the fluctuations of short-run growth. Increases in long-run growth are driven by expansions in aggregate supply.

The production possibility frontier and economic growth

The production possibility frontier (PPF) illustrates the maximum output combinations of two goods that an economy can achieve using all available resources efficiently. It helps visualise both short-run and long-run economic growth.

Representing short-run growth on the PPF

Short-run growth appears as a movement from one point inside the PPF curve to another point closer to or on the curve, while the curve itself stays in the same position.

Representing long-run growth on the PPF

Long-run growth is shown by an outward shift of the entire PPF curve, signifying an increase in the economy's productive capacity. This shift allows for greater output of goods due to factors like technological advancements or resource improvements.

Phases of the economic cycle and output gaps

Economies experience fluctuations in growth known as the economic cycle, which includes distinct phases with impacts on key indicators like unemployment and inflation. Output gaps measure how actual output compares to the trend level, highlighting under- or over-performance.

Phases of the economic cycle

• Boom - Rapid economic expansion where aggregate demand surges, unemployment drops, and inflation increases.
• Recession - At least two consecutive quarters of negative growth, with falling aggregate demand leading to higher unemployment and lower price levels.
• Recovery - Transition from negative to positive growth, where rising aggregate demand reduces unemployment and boosts inflation.

The trend rate of growth represents the average across these phases, providing a stable benchmark.

Output gaps

An output gap is the difference between actual output and trend output.

Types of output gaps:

• Negative output gap (recessionary gap) - Occurs when actual output falls below trend output, often during recessions. Resources are underused, including labour, leading to high unemployment and downward pressure on inflation.
• Positive output gap (inflationary gap) - Happens when actual output exceeds trend output, typically in booms. Resources are fully or overused, resulting in low unemployment and upward pressure on inflation.

During recovery, economies move from negative to positive output gaps as actual output surpasses the trend.

Showing output gaps on diagrams

Output gaps can be depicted on a PPF:

• Operating at full capacity means producing on the PPF curve.
• A negative output gap shows production inside the curve, with unused resources.
• A positive output gap indicates production beyond the curve, through overuse like extended working hours or strained machinery.

They can also be illustrated using aggregate supply and aggregate demand curves.

Causes of short-run and long-run economic growth

Short-run growth stems from immediate changes in demand or supply, while long-run growth focuses on building the economy's underlying capacity through supply-side improvements.

Causes of short-run economic growth

• Rise in aggregate demand - Shifts the aggregate demand curve rightward, driven by demand-side factors such as reduced interest rates (boosting investment and consumption) or higher welfare benefits (increasing government spending and consumption). The extent of the shift depends on the marginal propensity to consume and the size of the multiplier effect—a higher propensity and larger multiplier lead to a bigger shift.
• Rise in short-run aggregate supply - Shifts the short-run aggregate supply curve rightward, caused by factors that lower production costs, like falling oil prices or reduced wages.

Causes of long-run economic growth

Long-run growth results from supply-side factors that enhance productive potential by improving factors of production. This shifts the long-run aggregate supply curve rightward.

Examples include:

• Innovation, such as new technologies.
• Investment in modern machinery to upgrade capital stock.
• Boosting agricultural yields with genetically modified crops.
• Expanding education and training to develop human capital.
• Growing the workforce, for instance through immigration policies.

Governments support this by fostering economic stability to encourage investment and confidence.

Economic instability and shocks

Economies naturally experience minor ups and downs as part of the economic cycle, but extreme or frequent fluctuations can create problems. Governments may intervene to moderate these, though some events are beyond their control.

Understanding economic instability

The economic cycle involves regular expansions and contractions. Large or frequent swings can disrupt stability, affecting businesses and consumers.

Types of economic shocks

Sudden events, or shocks, can trigger growth or contraction.

These may be domestic or global and affect aggregate demand or supply:

• Demand-side shocks - Alter aggregate demand, e.g., rising consumer confidence from higher asset values increases spending, or a recession in key trading partners reduces export demand.
• Supply-side shocks - Impact aggregate supply, e.g., a poor harvest raises food prices and cuts capacity, or discovering new raw material sources lowers prices and expands capacity.