Economic Growth

You’ll be able to

Identify the sources of long-run economic growth
Explain how growth is shown as shifts of LRAS and the PPC
Analyze how investment in capital and productivity raises potential output

What drives long-run growth

Economic growth is a sustained increase in potential output (real GDP) over time — an expansion of the economy’s productive capacity, not just a short-run demand boom. Its sources are increases in the quantity and quality of resources: a larger or more skilled labor force (human capital through education and training), more physical capital (factories, machines, infrastructure), better technology, and more natural resources. Underlying most of these is productivity — output per worker — which rises when workers have more and better capital and know-how to work with.

Growth in the AD–AS and PPC models

Long-run growth is shown as an outward shift of the LRAS curve (and of the vertical LRPC’s counterpart, the potential-output level) — the economy can now produce more at full employment. In the PPC model, growth is an outward shift of the entire frontier, letting the economy produce more of both goods. The two models agree: whatever expands productive capacity — more capital, more labor, better technology — shifts both LRAS and the PPC outward. A short-run AD increase moves the economy toward its frontier but does not shift it; only capacity gains do.

Investment, saving, and future growth

Growth requires investment in capital, and investment must be financed by saving. Policies that encourage saving and investment — a stable financial system, protection of property rights, investment in infrastructure, education (human capital), and research and development — raise the future capital stock and productivity. There is an intertemporal trade-off: devoting resources to capital goods rather than consumer goods today sacrifices current consumption but shifts the PPC farther out tomorrow, delivering faster future growth.

Growth in real GDP

Growth rate of real GDP = [(Real GDP_new − Real GDP_old) / Real GDP_old] × 100

Sustained positive growth in *real* GDP (and in real GDP per capita, which divides by population) reflects a rising standard of living.

Worked example

A nation devotes a large share of its output to building capital goods (factories, machinery) rather than consumer goods, and invests heavily in education. Explain, using both the PPC and LRAS, how this affects the economy over time.

1.Producing more capital goods today means less consumption today — a movement toward the capital-goods axis on the current PPC.
2.The added physical capital and improved human capital raise the economy’s productive capacity.
3.Greater capacity shifts the entire PPC outward, allowing more of both consumer and capital goods in the future.
4.Equivalently, LRAS shifts right, raising potential real GDP at full employment.

Answer: Sacrificing current consumption to build capital and human capital raises future productive capacity: both the PPC and LRAS shift outward, so potential real GDP grows and future living standards rise. The cost is lower consumption today — an intertemporal trade-off.

Checkpoint

Which of the following would most clearly cause long-run economic growth, shown as a rightward shift of the LRAS curve?

Watch out

Distinguish a short-run AD increase (a movement toward the frontier, no shift in LRAS or the PPC) from long-run growth (an outward shift of LRAS and the PPC). Only changes in resources, capital, technology, or productivity shift potential output.

Checkpoint

A country chooses to produce more capital goods and fewer consumer goods this year, moving along its current production possibilities curve. What is the most likely long-run consequence?

On the exam

When a question asks about long-run growth, reach for capacity-expanding causes — capital, labor, human capital, technology — and show them as outward shifts of LRAS and the PPC. Do not answer a growth question with a short-run AD story.

Answer the 2 checkpoints as you read.