2.3.1a Determinants and effects of economic growth

Economic Growth Is a Rise in Real Output, Split Into Actual and Potential Growth

1. Real GDP is the total value of the goods and services an economy produces in a year, measured at constant prices so that inflation is stripped out.
2. Growth is the annual percentage change in real GDP from one year to the next.
3. Because prices are held constant, a rise in real GDP means the economy is producing more goods and services, not simply charging higher prices for the same output.

Actual Growth Uses Spare Capacity While Potential Growth Expands It

1. Actual growth is the rate of change of real output, real GDP, in the short run.
2. Potential growth is an increase in the productive capacity of the economy, which raises its long-run trend rate.
3. Short-run growth uses existing spare capacity more fully, while long-run growth expands the capacity itself.

Each Form of Growth Has Its Own Diagram

1. On a production possibility frontier, actual growth is a movement from inside the frontier towards the boundary, because idle resources are put back to work.
2. Potential growth is an outward shift of the whole frontier, because the economy can now produce more at full employment than it could before.
3. On an AD/AS diagram, potential growth is a rightward shift of long-run aggregate supply, with the axes labelled average price level and real output.

Growth Has Both Demand-Side and Supply-Side Determinants

1. Short-run growth comes from rises in the components of aggregate demand: consumption, investment, government spending and net exports.
2. Long-run growth, the trend rate, comes from more or better factors of production.
3. Investment, new technology, rising productivity, a larger or more skilled labour force, including immigration, and trade all raise the trend rate.

Growth Brings Real Benefits but Also Real Costs

1. For individuals, growth raises real incomes and living standards and creates jobs, cutting unemployment.
2. For the economy, higher output raises tax revenue to fund public services, though rapid growth can add to inflationary pressure if it outpaces capacity.
3. For the environment, growth can cause negative externalities such as pollution and congestion, and it can deplete finite resources.

2.3.1b The economic cycle and output gaps

The Economy Moves Through a Repeating Cycle Around a Rising Long-Run Trend

1. The economic cycle is the fluctuation of real output around its long-run trend.
2. Its four phases are boom, recession (a downturn), slump (or trough) and recovery.
3. Output rises and falls, but the long-run trend still points upward.

Real GDP, Inflation, Unemployment and Investment Reveal the Current Phase

1. In a boom, output and employment are high and prices tend to rise.
2. In a recession, output falls and unemployment rises.
3. Indicators such as real GDP, the rate of inflation, unemployment and investment together show which phase the economy is in.

A Slowdown Is Still Positive Growth, but a Recession Is Falling Output

1. A slowdown is slower positive growth, so output is still rising.
2. A recession is negative growth, so output is actually falling.
3. Telling actual growth apart from a slowdown in the rate of growth is essential for judging the cycle.

Name the Phase From the Data

Shocks at Home and Abroad Move the Economy Between Phases

1. Changes between phases are driven by demand-side and supply-side shocks.
2. Demand-side shocks shift aggregate demand: swings in consumer and business confidence, changes in investment, interest rate or tax changes, or a rise or fall in demand for exports.
3. Supply-side shocks shift aggregate supply: sharp changes in oil, energy or commodity prices, supply chain disruption, or changes in productivity.
4. Shocks can be domestic, such as a change in UK fiscal or monetary policy, or global, such as a world recession or a spike in world oil prices.
5. Cyclical instability can also build up from within: excessive growth in credit and levels of debt, asset price bubbles, destabilising speculation and animal spirits or herding, as in the boom that preceded the 2008 financial crisis.

An Output Gap Measures How Far Actual Output Sits From Its Potential

1. An output gap is actual output minus potential (trend) output.
2. A positive output gap is when actual output is above potential (trend) output.
3. A negative output gap is when actual output is below potential (trend) output.

A Positive Gap Sits Above Trend Output and a Negative Gap Below It

1. On an AD/AS diagram, the gap is the distance of actual output from the trend (potential) level.
2. A positive gap sits above trend output; a negative gap sits below it.
3. Gaps link directly to unemployment and inflation.
4. The gap can also be shown on a production possibility curve: a negative gap as production inside the curve, a positive gap as output beyond the sustainable trend.

Potential Output Is Unobservable, so Output Gaps Are Uncertain Estimates

1. Potential output cannot be observed directly.
2. So estimates of the gap are uncertain.
3. Policy based on them must allow for that uncertainty.

Tie the Gap to Inflation and Jobs

Output Gaps Guide Macroeconomic Policy but Must Be Read With Caution

1. An output gap signals where the economy sits relative to potential.
2. A positive gap points to inflation risk.
3. A negative gap points to spare capacity and unemployment.

A Positive Gap Argues for Tighter Policy and a Negative Gap for Looser Policy

1. A positive gap can prompt tighter policy to curb inflation.
2. A negative gap can prompt looser policy to support demand.
3. So the gap informs the policy stance.

Measurement Problems Limit How Far Output Gaps Should Steer Policy

1. For usefulness: gaps summarise the cycle in one measure.
2. Against: potential output cannot be observed directly.
3. Estimates are revised, so real-time judgements can be wrong.
4. On balance, output gaps are a useful guide to the cycle, but the difficulty of measuring potential output means they should inform, not dictate, policy.

Weigh Usefulness Against Measurement Problems