What Causes Economic Growth?

Economic growth is caused by an increase in aggregate demand (AD), an increase in an economy’s productive capacity, or both. Economic growth means an increase in real output: the amount of goods and services produced after allowing for changes in prices.

Scope: Cambridge International AS Level Economics 9708, 4.4 Economic growth, focusing on 4.4.4 causes of economic growth.

Growth from higher demand

AD is total planned spending in the economy. It can rise when households spend more, firms invest more, the government spends more, or exports increase relative to imports. Firms may respond by producing more and hiring workers. This is most likely to increase real output when the economy has spare capacity: workers and resources that are available but not being fully used. If firms are already producing close to capacity, extra demand may mainly raise prices instead.

Growth from greater productive capacity

An economy can also grow because it becomes able to produce more. Investment in machinery, better infrastructure, improved technology and education or training can help workers produce more per hour. Economists call this higher productivity. It can increase long-run aggregate supply (LRAS), meaning the economy can sustain a higher level of real output.

Investment can affect both routes: buying equipment adds to AD now and, once that equipment is in use, may raise future productive capacity. However, a shortage of skilled workers or unreliable transport can limit how much additional output firms produce.

For example, a firm that buys more efficient equipment may produce more with the same number of workers. If similar improvements occur across the economy, productive capacity rises.

Exam mistake to avoid: a rise in nominal GDP does not necessarily mean economic growth. Nominal GDP can rise simply because prices rise. Look for an increase in real GDP when judging whether output has grown.