7.1 - Economic Growth & Output Gaps - notes

Different types of economic growth

Economic growth reflects an expansion in what an economy can produce. It can occur in the short run or long run, with distinct causes and measurements.

Short-run economic growth

Short-run economic growth, also called actual growth, measures the percentage change in real national output, known as real gross domestic product (GDP).

Characteristics of short-run growth:

• This type of growth usually results from a rise in aggregate demand, though it can also stem from increases in aggregate supply.
• Actual growth does not rise steadily; it varies, sometimes increasing and sometimes decreasing.

Long-run economic growth

Long-run economic growth, or potential growth, happens when the economy's overall capacity expands.

Characteristics of long-run growth:

• This expansion typically arises from improvements in the quantity or quality of factors of production, such as advanced equipment or a better-trained workforce.
• Long-run growth appears as a rise in the trend rate of growth, which is the average growth rate across periods of economic highs and lows.
• Unlike actual growth, the trend rate increases steadily without sharp fluctuations, and actual growth rates often deviate from this trend.
• Increases in long-run growth are driven by rises in aggregate supply.

How a production possibility frontier shows economic growth

A production possibility frontier (PPF) illustrates the maximum output combinations of two types of goods an economy can achieve with its resources. It can demonstrate both short-run and long-run economic growth.

Short-run growth on a PPF

Short-run growth appears as a movement towards the PPF curve without shifting the curve itself. In the diagram below, which shows an economy producing capital goods and consumer goods, the economy moves from point A inside the curve to point B on the curve - this movement is short-run growth. The PPF remains unchanged because the economy's overall capacity has not expanded.

Long-run growth on a PPF

Long-run growth is shown by an outward shift of the PPF curve. This shift occurs when the economy's productive capacity increases, allowing more of both goods to be produced. In the diagram, the original PPF shifts outwards to PPF₁, reflecting enhancements like better technology or more resources that enable higher output levels.

Phases of the economic cycle

The economic cycle describes the fluctuations in actual economic growth over time, moving through distinct phases that affect key indicators like unemployment and inflation.

Key phases in the economic cycle

• Boom - The economy expands rapidly, with rising aggregate demand leading to lower unemployment and higher inflation.
• Recession - Negative growth persists for at least two consecutive quarters, causing falling aggregate demand, higher unemployment, and downward pressure on prices.
• Recovery - The economy shifts from negative to positive growth, with increasing aggregate demand reducing unemployment and pushing inflation upwards.
• Trend growth - This represents the average growth over full cycles of booms and recessions, showing a smoother upward path compared to the fluctuating actual growth.

These phases create a cyclical pattern where actual growth waves around the trend growth line, with peaks during booms and troughs during recessions. The diagram below shows this: real GDP rises steadily along the trend growth line over time, while actual growth fluctuates around it - climbing through a boom to a peak, falling through a recession to a trough, then rising again during the recovery.

Positive and negative output gaps

An output gap measures the difference between actual output and trend output, indicating whether the economy is performing below or above its potential. These gaps influence unemployment and inflation.

Negative output gaps

A negative output gap, or recessionary gap, occurs when actual output falls below trend output.

Characteristics of negative output gaps:

• This typically happens during recessions, where the economy underperforms with unused or underused resources, including high unemployment.
• It creates downward pressure on inflation due to reduced demand.

Positive output gaps

A positive output gap, or inflationary gap, arises when actual output exceeds trend output.

Characteristics of positive output gaps:

• This is common in booms, where the economy overheats with resources fully or overused, leading to low unemployment.
• It generates upward pressure on inflation from high demand.

During recoveries, economies often transition from negative to positive output gaps as actual output surpasses the trend. The diagram below shows both gaps: actual output fluctuates around trend output over time, opening a negative output gap where it dips below the trend and a positive output gap where it rises above it.

Showing output gaps on a PPF

Output gaps can be illustrated on a PPF diagram.

Output gaps on a PPF:

• Point X, inside the PPF curve, represents a negative output gap, as resources are not fully utilised.
• Point W, on the PPF curve, shows the economy at full capacity, with no output gap.
• Point Z, outside the PPF, indicates a positive output gap, where output temporarily exceeds potential through overuse of resources, such as extended working hours.

The diagram below shows these three points on an economy's PPF for capital goods and consumer goods.

Showing output gaps using AS and AD curves

Output gaps can also be depicted on aggregate supply (AS) and aggregate demand (AD) diagrams.

Output gaps on AS and AD diagrams:

• The long-run aggregate supply (LRAS) curve is vertical, marking the economy's full potential output, Yf. At point W, where the short-run aggregate supply (SRAS) curve crosses LRAS, the economy operates at this full potential.
• A negative output gap appears when the intersection of SRAS and aggregate demand (AD1) is to the left of LRAS - at point X, output Y1 is below potential, and the distance between Y1 and Yf is a negative output gap.
• A positive output gap occurs when the intersection is to the right of LRAS - if demand rises to AD2, the economy reaches point Z, where output Y2 is above potential, and the distance between Y2 and Yf is a positive output gap.

The diagram below shows both gaps, plotting the price level against real national output.