The definition of economic growth

Economic growth describes the expansion of an economy's productive capacity over a period. It is measured by the rise in real gross domestic product (GDP), which accounts for inflation to show genuine increases in output.

Measuring economic growth

Economic growth is quantified using the growth rate, which shows the percentage change in real GDP over time. This can be between years or quarters, and it may also use per capita real GDP to account for population changes.

Formula for calculating the growth rate

$\text{Growth rate}=\frac{{\text{rGDP}}_{\text{year 2 }}-{\text{ rGDP}}_{\text{year 1}}}{{\text{rGDP}}_{\text{year 1}}}\times 100$

Where:

• rGDP_{year 2} = Real GDP in the later year
• rGDP_{year 1} = Real GDP in the earlier year

A negative growth rate signals a recession, where real GDP falls. A positive but declining growth rate indicates the economy is expanding, though at a reduced pace.

Worked example - Calculating the growth rate

In 2021, an economy's real GDP was £2,500 billion. In 2022, it rose to £2,650 billion. Calculate the growth rate from 2021 to 2022.

Step 1: Identify the values

• rGDP₂₀₂₁ = £2,500 billion
• rGDP₂₀₂₂ = £2,650 billion

Step 2: Apply the growth rate formula

$\text{Growth rate}=\frac{\pounds \mathrm{2,650}-\pounds \mathrm{2,500}}{\pounds \mathrm{2,500}}\times 100$

Step 3: Calculate the growth rate

$\text{Growth rate}=\frac{\pounds 150}{\pounds \mathrm{2,500}}\times 100=6\%$

Short-term economic growth and its factors

Short-term economic growth arises from making better use of an economy's current resources, without altering its maximum potential output. It occurs when aggregate demand rises, shifting the aggregate demand (AD) curve rightwards. This can stem from boosts in any AD component: consumption (C), investment (I), government spending (G), or net exports (NX).

Factors that lead to short-term growth

• Improved confidence - Higher consumer and business optimism encourages more spending on goods and investments.
• Lower interest rates - Reduced borrowing costs prompt households to buy homes or durables, and firms to invest in equipment or facilities.
• Currency depreciation from low interest rates - A weaker currency makes exports cheaper and more competitive, while imports become costlier.
• Increased government spending - Direct boosts to public expenditure expand AD immediately.
• Lower direct taxes - Cuts in income or corporation taxes raise disposable income, potentially increasing consumption.
• Export-boosting elements - Currency depreciation, economic growth in trading partners, or reduced trade barriers enhance net exports.

Long-term economic growth and its factors

Long-term economic growth stems from enhancements in the quantity or quality of resources, or from technological progress, which raise an economy's potential output. This shifts the long-run aggregate supply (LRAS) curve rightwards, allowing sustained increases in real GDP.

Factors that lead to long-term growth

• Larger labour force - Growth through higher population, immigration, or increased participation rates provides more workers.
• Improved human capital - Investments in education and healthcare raise workforce skills and productivity.
• Expanded physical capital - Building more factories, machines, or tools increases production capacity.
• Better infrastructure - Developments in transport, energy, or communication networks support efficient operations.
• Technological progress - Innovations, especially in information and communication technology, drive efficiency gains and have historically been the primary source of long-term growth.
• Institutional improvements - Reduced bureaucracy, more flexible labour markets, and greater competition foster a productive environment.

Illustrating economic growth and dual impacts

Economic growth can be shown using models like AD/AS diagrams or production possibility curves (PPC). These illustrate how short-term and long-term growth differ, while some factors influence both.

Illustrating short-term growth

• In AD/AS models - A rightward shift in the AD curve raises real output. In Keynesian views, this may not increase prices if the economy has spare capacity. In monetarist or new classical models, it is ineffective beyond potential output.
• In PPC diagrams - The economy moves from a point inside the curve towards its boundary, producing more without shifting the curve itself.

Illustrating long-term growth

• In AD/AS models - A rightward shift in the aggregate supply (AS) or LRAS curve expands output at stable prices.
• In PPC diagrams - The entire curve shifts outwards, showing greater production possibilities for all goods.

Dual impacts of certain factors

Some elements affect both short-term and long-term growth:

• Government infrastructure spending - Boosts AD immediately (short-term) while enhancing capacity (long-term).
• Education investments - Increase current spending (short-term) and build human capital (long-term).
• Private sector investment - Raises AD now and expands capital stock for future output.