Understanding Economic Growth (Cambridge (CIE) A Level Economics): Revision Note

The meaning of economic growth

• Economic growth is an increase in the real output of goods and services produced by an economy over a period of time

  • It is measured as the percentage change in real GDP from one period to the next

• Economic growth can occur in two ways

1. Actual growth

• Actual growth is an increase in real output using previously unemployed or underemployed resources - the economy moves from a point inside the PPF towards the frontier

  • This occurs when spare capacity is brought back into use - for example during a recovery from recession

  • It does not increase the productive potential of the economy - the PPF does not shift

Diagram analysis

• Point X represents an economy operating inside the PPF - resources are unemployed or underemployed

• The movement from X to Y represents actual growth - real output increases as idle resources are brought back into production

• The PPF itself does not move - productive capacity is unchanged

• In AD/AS terms this is equivalent to a rightward shift of AD along the elastic section of the Keynesian LRAS - output rises but the price level remains stable while spare capacity exists

2. Potential growth

• Potential growth is an increase in the productive capacity of the economy - the maximum output the economy is capable of producing increases

• This is represented by an outward shift of the PPF

• It requires an increase in the quantity or quality of factors of production

• In AD/AS terms, potential growth is shown by a rightward shift of the LRAS curve

Diagram analysis

• The outward shift (A to B) represents an increase in productive capacity - caused by improvements in the quantity or quality of factors of production such as new technology, investment in capital, or an expansion of the labour force

• The inward shift represents economic decline - caused by destruction of capital, emigration of skilled workers, or depletion of natural resources

Diagram analysis

• The rightward shift from LRAS₁ to LRAS₂ increases the full employment level of output from Y_FE to Y_FE1

• At the same time the price level falls from AP₁ to AP₂ - potential growth is non-inflationary because productive capacity has increased

• This is the key distinction from an AD shift - demand-led growth raises prices; supply-led potential growth reduces them

Measurement of economic growth

• Economic growth is measured as the percentage change in real GDP between two time periods

• Growth is typically measured on a quarterly basis (every three months) and reported as an annual rate

• A recession is technically defined as two consecutive quarters of negative GDP growth

• Long-run trend growth refers to the average rate at which an economy can grow without generating inflationary pressure - in the UK this is approximately 2-2.5% per year

Distinction between nominal GDP and real GDP

• Nominal GDP is the total value of output measured at current prices - it makes no adjustment for inflation

  • Nominal GDP can rise simply because prices have risen, even if the actual volume of goods and services produced has not increased

  • It therefore overstates true economic growth in periods of inflation

• Real GDP is the total value of output measured at constant prices - it adjusts for inflation by using a base year price level

  • Real GDP strips out the effect of price changes, leaving only the change in the volume of output

  • It is the correct measure for assessing whether living standards have actually improved

• The difference between nominal and real GDP growth is explained by the rate of inflation:

Real GDP growth = Nominal GDP growth - Inflation rate

• A country reporting strong nominal GDP growth may actually be experiencing falling real output if inflation is sufficiently high

  • This is why real GDP is always used when comparing economic performance over time or between countries