Actual and potential growth, and the output gap

• Actual growth — a rise in real GDP. On an AD/AS diagram it is a rightward shift of AD (or a movement towards LRAS); on a PPF it is a move from inside the frontier towards it.
• Potential growth — a rise in the economy's productive capacity. LRAS shifts right; the whole PPF shifts outwards. Caused by more or better factors of production: investment, education, technology, migration, institutions.

The economic cycle: boom → slowdown → recession → recovery. Technically a recession in the UK is two consecutive quarters of negative real GDP growth.

• Benefits of growth: higher incomes and living standards, lower unemployment, more tax revenue (funding public services without raising rates), reduced absolute poverty, higher business profits and confidence.
• Costs of growth: inflation if it outstrips capacity, negative externalities (pollution, congestion, resource depletion), a possible current account deficit (imports suck in as incomes rise), widening inequality (the gains are rarely shared evenly), and the stress of rapid structural change.

The nuance examiners reward: output gaps are estimated, never observed — nobody can see potential output. Policy that assumes a large negative gap when there is really none delivers inflation, not output. That uncertainty is a serious constraint on demand management.

Your turn — real GDP growth

What actually causes long-run growth?

Potential growth comes from more or better factors of production — and, above all, from productivity.

• Capital — investment in machines, factories and infrastructure raises output per worker (capital deepening).
• Labour — a bigger workforce through population growth, net migration, or higher participation (childcare, pension age).
• Human capital — education, training, health. Raises the MRP of every worker.
• Technology and innovation — the single biggest driver of long-run growth, and the reason R&D and dynamic efficiency matter so much (4.1.5).
• Institutions — secure property rights, rule of law, low corruption, competitive markets. Poor institutions can nullify everything else.
• Natural resources — helpful, but beware the resource curse.

Sustainable growth means growth that does not store up problems — inflation, a ballooning current account deficit, environmental destruction, or an unsustainable credit boom. Growth built on a house-price bubble is not sustainable growth, as 2008 demonstrated.

Your turn — the output gap

Demand-pull, cost-push and the costs of inflation

Inflation is a sustained rise in the general price level; it is not a rise in one price, and it is not the same as a high price level.

• Demand-pull inflation — AD rises faster than the economy can supply. Too much money chasing too few goods. On the diagram, AD shifts right along an upward-sloping or vertical AS. Causes: a consumer or house-price boom, a fiscal stimulus, low interest rates, rapid export growth, a depreciation.
• Cost-push inflation — SRAS shifts left as costs rise: energy and commodity prices, wage rises above productivity, a depreciation making imports dearer, higher indirect taxes. It gives higher prices AND lower output — stagflation, the policy-maker's nightmare, because fixing one worsens the other.
• The monetarist view (Friedman): inflation is always and everywhere a monetary phenomenon. MV = PQ — if the money supply grows faster than real output, prices must rise.

Costs of inflation: falling real incomes if wages lag; erosion of savings; loss of international competitiveness; menu costs and shoe-leather costs; uncertainty deterring investment; arbitrary redistribution from savers and lenders to borrowers; and the danger of a wage–price spiral once expectations become unanchored. High inflation is also regressive — the poor spend more of their income on food and energy.

Deflation is worse. A sustained fall in the price level makes consumers delay purchases (things will be cheaper next month), so AD falls further; the real value of debt rises (debt deflation); and real interest rates rise even at a zero Bank Rate. Japan spent decades stuck there. Distinguish it from disinflation — inflation still positive but falling — which is usually good news.

Your turn — the inflation rate from a CPI index

Diagnose the inflation

Expectations and the wage-price spiral

The most dangerous feature of inflation is that it can become self-fulfilling.

• Prices rise → workers expect further rises → they demand higher money wages to protect real pay → firms face higher costs → they raise prices → workers expect further rises. This is the wage–price spiral, and it converts a one-off shock into persistent inflation.
• Once inflation expectations become unanchored, only a severe contraction — a deep recession with a high sacrifice ratio (the output lost per percentage point of inflation removed) — can bring inflation back down. That was the price paid in the early 1980s.

Which is why central bank credibility is priceless. If everyone believes the Bank will hit its 2% target, they build 2% into wage bargains and price-setting, and the target becomes self-fulfilling in the good direction. Expectations do the Bank's work for free. This is the deepest argument for an independent, transparent central bank with a clear mandate — and it is the same insight as the expectations-augmented Phillips curve, seen from the policy side.

Second-round effects is the phrase to use: an energy shock is a one-off price level increase unless it feeds into wages and inflation expectations. Whether it does is the difference between a bad year and a lost decade.

Types of unemployment, the natural rate and hysteresis

• Frictional — short-term, between jobs. Some is inevitable and even healthy (it means people are matching to the right job). Reduced by better information and lower benefits.
• Structural — a mismatch between the skills/location workers have and those employers want, caused by long-run change in the structure of the economy (deindustrialisation, automation, trade). Made worse by occupational immobility (wrong skills) and geographical immobility (housing costs, family ties). This is supply-side unemployment: more AD will not fix it — only retraining, education and mobility will.
• Cyclical (demand-deficient) — caused by a fall in AD in a recession. This is curable by demand-side policy (fiscal or monetary stimulus).
• Seasonal — predictable variation over the year (tourism, agriculture, construction).
• Real-wage (classical) — wages held above the market-clearing level (by unions or a minimum wage) so quantity supplied of labour exceeds quantity demanded.

The natural rate of unemployment (NRU / NAIRU) is the rate that persists when the labour market is in equilibrium — the sum of frictional, structural and real-wage unemployment. It is the rate at which inflation is stable. It cannot be reduced by AD; only by supply-side policy.

Hysteresis — a deep recession can raise the natural rate permanently. The long-term unemployed lose skills, work habits, confidence and contacts; employers discriminate against them; some drift into inactivity. A temporary demand shock thereby becomes permanent structural damage. It is the strongest argument for intervening fast and hard in a recession — and it was the explicit justification for furlough in 2020.

Which type of unemployment?

Tap a case, then tap the type of unemployment it illustrates.

The short-run and long-run Phillips curve

A.W. Phillips (1958) found an inverse relationship in UK data between wage inflation and unemployment: an apparent trade-off that governments could exploit — accept a bit more inflation to buy lower unemployment.

Then the 1970s delivered stagflation — high inflation AND high unemployment together — which the simple curve said was impossible.

Friedman and Phelps supplied the fix: the expectations-augmented Phillips curve. Each short-run Phillips curve (SRPC) is drawn for a given expected inflation rate.

• Expand AD → inflation rises above what workers expected → real wages fall → firms hire → unemployment falls below the NRU. But this is a money illusion, and it is temporary.
• Workers see prices rising and revise their expectations up. They demand higher money wages. Real wages return to their old level, firms shed the extra workers, and unemployment returns to the NRU — but now at permanently higher inflation. The SRPC has shifted up.
• So the long-run Phillips curve (LRPC) is VERTICAL at the natural rate: there is no long-run trade-off. Any attempt to hold unemployment below the NRU produces accelerating inflation.

Two policy consequences you can use anywhere: (1) to cut unemployment permanently you must cut the NRU with supply-side policy, not with AD. (2) Credibility matters enormously — if the central bank is trusted, expectations stay anchored, the SRPC does not shift up, and inflation can be brought down at a much lower cost in lost output (a lower sacrifice ratio). That is the whole rationale for an independent Bank of England.

No long-run trade-off

Conflicts between macroeconomic objectives

• Growth vs inflation — rapid AD-led growth, especially near full capacity, causes demand-pull inflation. The classic short-run Phillips trade-off.
• Growth vs the balance of payments — as UK incomes rise, so do imports (a high MPM), worsening the current account deficit.
• Growth vs the environment — more output means more emissions, congestion and resource depletion, unless growth is decoupled from carbon.
• Unemployment vs inflation — the Phillips trade-off, in the short run only.
• Growth vs equality — the gains from growth often accrue to capital owners and the highly skilled, widening inequality.
• Reducing the deficit vs growth — austerity cuts G and raises T, which cuts AD and (via the multiplier) can shrink GDP and even raise the debt-to-GDP ratio. The 2010s UK debate in one line.

Are the conflicts inescapable? No — and this is where the best answers go. Supply-side policy can shift LRAS right, delivering growth and lower inflation and lower unemployment and better competitiveness at the same time. Its problems are that it is slow, expensive, and its success is uncertain. That is why governments keep reaching for demand-side tools instead — and keep running into the trade-offs.

Match the macro concept

Tap a description on the left, then the concept it defines.

Match the policy to the cause

Spot the stagflation

The costs of unemployment

Unemployment is not just a number on a chart. AQA wants the full range of costs:

• To the individual: lost income; falling living standards; deskilling and lost confidence; measurably worse physical and mental health; a permanent scar on lifetime earnings (especially for the young).
• To firms: lower demand for their products; but a larger pool of applicants and weaker wage pressure.
• To the government: lower tax revenue AND higher benefit spending — a double hit to the budget deficit.
• To society: lost output — the economy operates inside its PPF with a negative output gap; higher crime and social problems; wider inequality and higher relative poverty; and through hysteresis, permanent damage to productive capacity as LRAS itself shifts left.

The counterweight: some frictional unemployment is efficient — it means workers are searching for the right match rather than taking the first job going. And zero unemployment would mean an overheating labour market with accelerating wage inflation. The target is the natural rate, not zero.

The big ideas to know

You have covered the whole of AQA 4.2.3. Press Finish to see your score.