What Actually Raises Long-Run Growth

You’ll be able to

Distinguish policies that shift AD from policies that shift LRAS
Identify the determinants of long-run growth in potential output
Explain why productivity growth is the only sustainable source of rising living standards

Growth is an LRAS question, not an AD question

Closing a recessionary gap and raising long-run growth are different problems with different answers. Demand policy moves output toward potential; growth policy moves potential itself. A stimulus that closes a gap does nothing for the growth rate once the gap is closed. This distinction is the organizing idea of the unit, and a free response that offers expansionary fiscal policy as a growth strategy has answered the wrong question.

What shifts LRAS right

more labor · more physical capital · more human capital · better technology · stronger institutions and property rights · more efficient resource allocation

Every genuine growth policy operates through one of these. If a proposal does not, it is a demand policy.

Productivity is what raises living standards

GDP per capita can rise for a while by putting more people to work or working longer hours, but those have limits. The only unlimited source is productivity — output per worker-hour — which comes from capital deepening, human capital and technology. This is why growth policy is mostly about investment and education, and why the loanable funds market matters so much: it is the mechanism by which saving becomes the capital that raises productivity.

Specific policies, with their trade-offs

Investment tax credits and lower capital taxes raise investment, at the cost of revenue. Education and training raise human capital, but slowly — the payoff is decades out. Infrastructure raises private-sector productivity, if the projects are well chosen. Research funding and patent protection raise the rate of technological progress. Reducing the deficit frees saving for private investment. Note the common shape: these all involve current sacrifice for future output, which is exactly why they are politically harder than demand stimulus.

Worked example

Compare an increase in government transfer payments with an investment tax credit of equal size, in the short run and the long run.

1.Transfers raise household disposable income, so C rises: AD shifts right. Output rises toward potential, price level rises.
2.Transfers do not raise the capital stock or productivity, so LRAS is unchanged.
3.The tax credit also raises AD, through I rather than C.
4.But it additionally raises the capital stock over time, shifting LRAS right.

Answer: Both raise AD in the short run. Only the investment credit shifts LRAS right, raising potential output permanently. Equal short-run stimulus, very different long-run consequences — the standard comparison this unit tests.

Watch out

Do not call expansionary monetary or fiscal policy a growth policy. It closes gaps. Growth requires more resources or better technology, and no amount of demand management supplies either.

Checkpoint

Which policy would shift LRAS to the right?

Checkpoint

Sustained increases in real GDP per capita depend primarily on growth in:

Checkpoint

A country reduces its budget deficit substantially. The long-run growth effect is that:

On the exam

A question asking for a policy to raise long-run growth wants a supply-side answer. Name the channel — capital, human capital, technology — rather than just the policy, since the channel is usually where the point is awarded.

Answer the 3 checkpoints as you read.