Economic growth
Key terms
Define each term.
Multiple choice
Circle the correct answer.
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?
An economy recovering from a deep recession records 4% real GDP growth. Which is the most likely explanation?
Worked problems
Show your working.
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.
Chains of reasoning
The steps are in the wrong order. Write the letters in the order that makes a linked chain.
How investment delivers both kinds of growth
- A Productive capacity increases, so LRAS shifts right and potential output grows.
- B The economy can now sustain a higher level of output without generating inflation, so growth is non-inflationary rather than merely cyclical.
- C Workers with more and better equipment produce more per hour, so labour productivity rises.
- D Investment is a component of aggregate demand, so AD shifts right immediately and actual output rises.
- E Over the following years the new capital comes into use, so the capital stock per worker rises.
- F The multiplier amplifies this, since the firms supplying the machinery gain income and spend part of it.
- G Firms increase investment in new machinery and buildings, perhaps following a fall in interest rates or a cut in corporation tax.
Diagrams
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.
Draw a production possibility curve with a point inside it. Show actual growth as a movement from that point towards the curve, and potential growth as an outward shift of the curve itself. Then draw an AD/AS diagram showing the same two things: an AD shift along a flat AS, and a rightward shift of LRAS.
Answers
Economic growth: An increase in the real output of an economy over time, usually measured as the percentage change in real gross domestic product.
Recession: A period of falling real GDP, usually defined as two consecutive quarters of negative economic growth.
Output gap: The difference between the actual level of real GDP and the potential level the economy could produce with all its resources fully employed. A negative output gap means actual output is below potential; a positive gap means it is temporarily above it.
C. Real growth is approximately nominal growth minus inflation, so 5% - 8% = -3%. Prices rose faster than the value of output, which means the actual quantity of goods and services produced fell. The economy contracted despite a positive headline figure.
C. Education raises what each worker can produce, so productive capacity itself increases and the effect is permanent. The other three raise demand and therefore current output, but leave capacity unchanged, so their effect fades. A lower savings rate arguably reduces long-run growth by financing less investment.
B. Recessions leave labour and capital unemployed, so recovery raises output by using capacity that already exists. This is actual growth without potential growth, which is why recovery growth rates are often high and then slow once the economy reaches its trend level. Capacity generally grows more slowly during a recession, not faster, because investment falls.
Step 1. Apply the relationship. Real GDP growth = nominal GDP growth - inflation = 7% - 4% = 3%.
Step 2. Check against the exact calculation. Exactly: (1.07 / 1.04) - 1 = 0.0288, or 2.88%. The approximation of 3% is close enough at these rates.
Step 3. Interpret the result. Output of actual goods and services rose by about 3%. The remaining 4 percentage points of the headline figure were prices rising, not more being produced.
Step 4. Recalculate with higher inflation. Real growth = 7% - 9% = -2%. Real output has fallen even though GDP at current prices rose by 7%. The economy contracted while the headline number went up.
Step 5. Draw the wider point. A rising nominal figure tells you nothing on its own. In a high-inflation economy, impressive-looking growth in current-price GDP can conceal a shrinking real economy, which is why every serious comparison is made in real terms.
Step 4 is where the marks are. Candidates who can produce a negative real growth rate from a positive nominal one have understood the distinction; those who report 3% and stop have only done arithmetic.
G, D, F, E, C, A, B
- Firms increase investment in new machinery and buildings, perhaps following a fall in interest rates or a cut in corporation tax.
- Investment is a component of aggregate demand, so AD shifts right immediately and actual output rises.
- The multiplier amplifies this, since the firms supplying the machinery gain income and spend part of it.
- Over the following years the new capital comes into use, so the capital stock per worker rises.
- Workers with more and better equipment produce more per hour, so labour productivity rises.
- Productive capacity increases, so LRAS shifts right and potential output grows.
- The economy can now sustain a higher level of output without generating inflation, so growth is non-inflationary rather than merely cyclical.
Investment is the one variable that appears on both sides of the model, raising demand now and supply later, and saying so explicitly is worth marks. It is also why investment is the component of AD that policy most often tries to protect during a downturn.
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.
Drawing both pairs is the point, because the same distinction appears in two diagrams and questions use either. On the PPC, actual growth uses capacity and potential growth creates it. On AD/AS, an AD shift raises output only while spare capacity exists, whereas an LRAS shift raises the sustainable level itself.