Causes of growth
Definition
Demand-side causes: factors that raise aggregate demand and so use up existing spare capacity.
Supply-side causes: factors that raise the quantity or quality of the factors of production, expanding productive capacity.
Demand-side causes
- Higher consumer spending, investment, government spending or net exports all raise aggregate demand.
- Firms respond by using idle machinery and hiring unemployed workers, so real output rises.
- This boost fades once spare capacity is used up, so it mainly works in the short run.
Example
- Suppose the central bank cuts interest rates from 5% to 4%, so borrowing becomes cheaper.
- Households buy more on credit and firms invest, so a firm with idle capacity raises production and adds, say, £10bn to real GDP in the short run.
Supply-side causes
- In the long run, growth comes from increasing the quantity or quality of the factors of production.
- Investment in new capital and infrastructure raises the economy's productive capacity.
- Better education and training raise labour productivity, so each worker produces more.
- New technology allows more output to be produced from the same inputs.
- A larger labour force, through population growth or migration, also adds to capacity.
Example
- Suppose a country invests £20bn a year in schooling and in new factories.
- Its workforce becomes more productive and its capital stock grows, raising potential output over many years.
Short run versus long run
- Using spare capacity gives only a temporary, short-run rise in output.
- Expanding productive capacity supports growth over the long run.
- Lasting growth therefore depends mainly on supply-side improvements.
- It depends on spare capacity: in a boom a demand boost may only raise prices, whereas with idle resources it raises real output.
Note
- At AS level, focus on whether a cause raises actual output or productive capacity.
- The formal distinction between actual and potential growth is developed at A Level.
Exam technique
- Group causes clearly into demand-side and supply-side.
- State whether each cause works in the short run or the long run.
Common Mistake
- Do not confuse using spare capacity with expanding capacity.
- The first is a short-run demand-side effect and the second a long-run supply-side effect.
Self review
- Name a demand-side cause of growth.
- Name a supply-side cause of growth.
- How can investment raise long-run growth?
- Why does demand-side growth fade once spare capacity is used up?
