Actual versus potential growth

• Actual growth — an increase in real GDP actually produced. Driven by a rise in AD (C, I, G or X − M), typically using up existing spare capacity. On a PPF, it is a movement from inside the curve towards it. It is the short-run story, and it is constrained: once spare capacity is gone, more AD only causes inflation.
• Potential growth — an increase in the economy's productive capacity. Driven by a rise in the quantity or quality of the factors of production, i.e. a rightward shift of LRAS. On a PPF, the whole curve shifts outwards. This is the long-run story and is the only route to sustained rising living standards.

Causes of potential growth (the LRAS shifters of 2.3.3): net investment in physical capital · technological advance · improved education and skills (human capital) · net inward migration of working-age people · discovery of new natural resources · better infrastructure · more effective competition policy.

Export-led growth (2.5.1c). Exporting escapes the limits of the domestic market. It lets firms exploit economies of scale, forces them to compete against the world's best (driving dynamic efficiency), earns the foreign currency needed to import capital goods, and improves the current account. It is the model behind Germany, South Korea and China. Evaluate: it leaves the economy exposed to a global downturn or to protectionism in your export markets, and it may require a competitive (weak) exchange rate that raises import costs.

Your turn — the growth rate

Output gaps

The long-term trend rate of growth is the average sustainable rate at which the economy's productive capacity grows (for the UK, historically around 2–2.5% a year, though it has been weaker since 2008). Actual growth fluctuates around that trend. The output gap is the difference between actual and potential (trend) output.

• Negative output gap — actual output is below potential. There is spare capacity: unemployed workers, idle machines. Downward pressure on inflation. On an AD/AS diagram, AD cuts AS on its elastic (flatter) section, well below full capacity.
• Positive output gap — actual output is above potential. The economy is running "hot": firms use overtime and pay bonuses to squeeze out extra output, but they cannot sustain it. Labour and material shortages bid up costs → inflationary pressure. AD cuts AS on its steep section.

The difficulty of measurement (2.5.2b) — a top-band evaluation point. Potential output is not observable. It has to be estimated from a model, and different institutions (the OBR, the Bank of England, the IMF) publish materially different estimates of the same output gap. GDP data are also revised repeatedly for years afterwards. So a policymaker may tighten policy believing there is a positive gap when in fact there was spare capacity all along — a direct route to government failure. Never quote an output gap as if it were a fact.

Your turn — the output gap

The trade cycle

Real GDP does not grow smoothly — it moves in cycles around the trend, with four phases: boom → slowdown/downturn → recession (trough) → recovery.

Characteristics of a BOOM:

• Actual growth above trend; a positive output gap; the economy near or beyond full capacity.
• Low unemployment (mostly frictional); labour shortages; wages bid up.
• Rising inflation (demand-pull), high consumer and business confidence, strong investment, rising asset prices.
• Government finances improve: tax revenue is buoyant and benefit spending falls (automatic stabilisers).
• The current account tends to worsen, as high incomes suck in imports.

Characteristics of a RECESSION (technically: two consecutive quarters of negative real GDP growth):

• A negative output gap and substantial spare capacity.
• Rising cyclical (demand-deficient) unemployment; falling real incomes.
• Falling inflation (disinflation), possibly deflation; collapsing confidence; investment falls sharply (the accelerator).
• Government finances deteriorate: tax revenue falls, benefit spending rises, so the budget deficit widens automatically.
• Business failures and, if the downturn is long, hysteresis — a permanent loss of skills that lowers LRAS.

What drives the cycle? The multiplier and the accelerator interacting (2.2.3, 2.4.4): a rise in AD raises income, which raises investment, which raises AD again — and the same mechanism amplifies the downswing. Add Keynes's volatile animal spirits, credit cycles and asset-price bubbles, and you have the cycle.

Match the phase to its description

Watch the difference between a slowdown and a recession — this is a classic exam trap.

Actual or potential?

Sort: actual growth, potential growth, or a cost of growth?

AD-side → actual. LRAS-side → potential. Third parties suffering → a cost.

Your turn — compound growth

Your turn — the rule of 70

The benefits and costs of growth

Benefits:

• Consumers — higher real incomes, more goods and services, greater choice; higher employment and job security.
• Firms — higher demand, higher profits, greater confidence, more investment, and economies of scale from larger output.
• Government — higher tax revenue and lower benefit spending, so the budget deficit falls without raising tax rates. That funds better public services — and can fund the environmental protection growth may damage.
• Living standards — sustained growth is the single most powerful force for reducing absolute poverty in history. It also funds better healthcare, education and life expectancy.

Costs:

• Inflation — if growth is demand-led and outruns capacity (a positive output gap), inflation accelerates and may have to be crushed with a painful recession.
• Environmental damage — pollution, congestion, carbon emissions, resource depletion. These are negative externalities (1.3.2) not captured in GDP: growth measured this way overstates the true gain.
• Inequality — the gains may accrue disproportionately to owners of capital and the highly skilled, so relative poverty can rise even as the average rises. Growth does not automatically trickle down.
• Current account deficit — rising incomes suck in imports.
• Opportunity cost — potential growth requires investment, which means less consumption today (the capital-vs-consumer-goods trade-off of 1.1.4). Future generations gain; the current one pays.
• Non-material costs — longer hours, stress, erosion of leisure and community. And beyond a threshold, the Easterlin paradox (2.1.1g): more GDP buys little extra happiness.

Sustainable growth is the reconciling idea: growth that "meets the needs of the present without compromising the ability of future generations to meet their own needs" (Brundtland). It requires growth driven by productivity and clean technology, not by burning through non-renewable resources.

Output gaps

Does growth raise living standards?

Measuring the output gap

The big ideas to know

Press Finish to see your score.