An economy growing at 1% a year doubles its output in seventy years, roughly a working lifetime. One growing at 7% doubles it in ten. Two countries starting level, separated by six percentage points of growth, will be unrecognisably different within a generation, and that gap is the single largest fact in economic history. Almost everything governments do to the macroeconomy is an attempt to move that number, which is why understanding what actually causes growth matters more than any other topic on the syllabus.
Economic growth
An increase in the real output of an economy over time, usually measured as the percentage change in real gross domestic product.
The word real is the mark. If output is measured at current prices, a figure can rise purely because prices rose while the same quantity of goods was produced. Real GDP strips inflation out, so a rise in real GDP means more goods and services, not dearer ones. A definition without 'real' is routinely marked down.
Approximate real GDP growth = nominal GDP growth - rate of inflationThe exact form is (1 + nominal growth) / (1 + inflation) - 1, which matters only when the rates are large. Cambridge accepts the subtraction. Formulae are not printed in any 9708 paper, so recall it.
Separating real growth from inflation
A country reports that its GDP measured at current prices rose by 7% last year. Inflation over the same period was 4%. Calculate the approximate real growth rate. Then state what would have happened to real output if inflation had been 9% instead.
What causes growth
Growth comes either from having more factors of production or from using them better. More labour comes from a rising population, higher participation or immigration. More capital comes from investment, meaning spending on machinery, buildings and infrastructure rather than on consumer goods. More land and raw materials may come from discovery or from bringing unused land into use. Using factors better means raising productivity, through education and training, better technology, improved management or increased specialisation. In the long run productivity matters most, because an economy cannot keep adding workers and machines forever but can keep getting better at using them.
Growth does not proceed smoothly. The business cycle describes the pattern economies follow around their long-run trend. In a boom, output is high and rising, unemployment is low and inflationary pressure builds. A downturn follows as demand weakens and growth slows. A recession, conventionally two consecutive quarters of falling real GDP, brings rising unemployment and falling confidence. Recovery then begins as demand returns and output rises back towards trend. The cycle is why an economy can have a strong long-run growth rate and still spend some years shrinking.
Draw a diagram with real GDP on the vertical axis and time on the horizontal axis. Draw a straight upward-sloping trend line, then draw the actual path of GDP as a wave oscillating around it. Label boom, downturn, recession and recovery, and mark where unemployment would be highest and where inflationary pressure would be greatest.
Two things to get right. The trend line slopes upward, because long-run growth continues through the cycle; drawing it flat implies an economy that never grows. And the actual path crosses the trend line rather than merely touching it, since an economy in a boom is producing above its sustainable level, which is precisely why booms end.
Growth is desirable but not costless, and questions almost always want both sides. It raises average incomes and material living standards, creates jobs, and increases tax revenue so a government can fund healthcare and education without raising rates. Against that, growth can generate pollution and deplete non-renewable resources, and the benefits may go disproportionately to those who already have most, so inequality can widen even as the average rises. Rapid growth can also be inflationary, and producing more capital goods now means fewer consumer goods today. Whether growth is worth having is rarely the question; how it is achieved and who receives it usually is.
A country's GDP at current prices rises by 5% while inflation is 8%. What has happened to real GDP?
Which of the following would raise an economy's long-run growth rate rather than simply its current output?