2.3.5 - Economic growth

Actual growth is movement of current output; potential growth is outward movement of capacity. Actual output can rise towards unchanged capacity, while capacity can rise without being fully used.

Aggregate demand is $AD=C+I+G+(X-M)$. A rise in consumption, investment, government expenditure or net exports shifts AD to the right, ceteris paribus.

With spare capacity, firms can respond mainly by raising real output and employment. Near full capacity, the same AD increase is more likely to raise the price level and produce less real growth.

Export-led growth occurs when expanding exports are a major driver of rising real GDP. Stronger foreign demand raises $X$, net exports and aggregate demand.

Higher exports increase firms' orders and revenue, so they expand output and employment. The new incomes generate further consumption through the multiplier. Repeated access to larger markets can also encourage investment, specialisation, learning and economies of scale.

These changes increase the quantity or productivity of factors of production, shifting LRAS to the right and moving the production possibility frontier outwards.

The effect depends on implementation and quality: investment can be misallocated, migration's impact depends on skills and participation, and excessive or weak competition can reduce innovation incentives.

Productivity measures output per unit of input, commonly real output per worker or per hour worked. For labour productivity: $productivity=real\ output/labour\ input$.

Higher productivity lets the same labour and other inputs produce more. It can lower unit costs, improve competitiveness and shift LRAS to the right, raising potential growth.

If lower costs improve net exports or higher expected returns stimulate investment, AD may also rise. However, the new capacity produces actual growth only when there is sufficient demand to use it.

Benefits depend on growth per person, distribution, sustainability, spare capacity and the type of output. Real GDP can grow while median living standards stagnate or environmental quality falls.

The size of each cost depends on the source, pace and policy framework of growth. Cleaner technology, carbon pricing, redistribution and supply expansion can alter the trade-offs.

The actual growth rate is the percentage change in real GDP over a period: $((real\ GDP_t-real\ GDP_{t-1})/real\ GDP_{t-1}) imes100$. The long-term trend growth rate is the estimated sustainable average rate at which potential output grows.

The output gap is the difference between actual real output and estimated potential real output, often expressed as a percentage of potential output: $gap=((Y-Y^*)/Y^*) imes100$.

Identify actual equilibrium output, identify potential output at LRAS, compare their horizontal positions, and label the distance between them. A leftward AD shift can create or widen a negative gap.

A positive gap commonly follows AD exceeding sustainable capacity; a negative gap commonly follows deficient AD. Supply shocks and changing potential output can also change the gap, so diagnose both actual and potential output.

These are tendencies, not definitions. Inflation can coexist with a negative gap after an adverse supply shock, and unemployment never falls to zero because frictional and structural unemployment remain.

Actual GDP is estimated, but potential output cannot be directly observed. Analysts must estimate the output consistent with sustainable factor use and stable inflation.

Two credible estimates may differ in size or even sign, and real-time estimates can be revised later. Policy based on a falsely positive gap may be too tight; policy based on a falsely negative gap may intensify inflation.