Economic growth is the increase in an economy’s real Gross Domestic Product (GDP) in the short run and increase in its productive potential in the long run. Real GDP is the output of the economy that has been adjusted for inflation. Growth in the short run is also referred to as actual economic growth because the output of the economy increases. Growth in the long run is sometimes referred to as potential economic growth because the economy’s capacity to produce expands.
Economic growth in the short run
Many countries operate within their Production Possibility Curves (PPC) in the short run. In other words, resources are not fully or efficiently utilised in the short run owing to low aggregate demand. That is to say, there will be idle resources because it is needless to fully use resources when there is not enough demand for goods and services. There is economic growth as more of the existing resources are used to increase output. It can be represented by a movement from one point to another within the PPC (from A to B in Figure 1 below). It can also be from a point within the PPC to another point on the PPC (from B to C in Figure 1 below). In both cases, the output increases.
Figure 1: Actual economic growth
The cause of economic growth in the short run
The reason why there is economic growth in the short run is a rise in aggregate demand. If aggregate demand increases, resources will be mobilised to meet up with it. Therefore, the economy’s output will be expanded in response to rising aggregate demand. Aggregate demand can rise as a result of a change in any of its components, namely consumption, investment, government expenditure and net exports. For example, a lower interest rate or increased consumer confidence would encourage households to increase their consumption. Increased consumption will raise aggregate demand. In Figure 2 below, aggregate demand rises from AD to AD1 leading to a rise in national output from Y to Y1 (economic growth). The government can use expansionary demand-side policies to stimulate short run economic growth. However, there may be inflation if the economy is already operating at or near its potential. A rise in aggregate demand results in an increase in the price level from P to P1 (see Figure 2 below). The potential output of the economy is PF (the maximum output that can be produced when resources are fully and efficiently used).
Figure 2: Economic growth caused by a rising aggregate demand
Economic growth in the long run
A country is expected to operate on its PPC in the long run. Resources should be fully utilised in the long run in order to produce maximum output for a country. Growth in the long run, therefore, means that the productive potential or capacity of the economy to produce has increased. This will lead to an outward shift in the PPC (see Figure 3 below). Long run economic growth does not create inflationary pressure in the economy as it prevents aggregate demand from exceeding aggregate supply by increasing the long run average supply (LRAS) and making more products available. In Figure 4 below, the price level remains at P even though aggregate demand rises from AD to AD1. This is because LRAS curve shifts rightwards from LRAS to LRAS1.
Figure 3: Potential economic growth
Causes of economic growth in the long run
Economic growth in the long run means that the productive potential or the capacity to produce has increased. Since resources are fully utilised in the long run, the only way to grow is to increase the quantity and quality of resources. Resources are inputs in the production process.
Figure 4: Shift in the aggregate supply curve in the long run
A. Increase in the quantity of resources
Positive net migration
Net migration is the difference between the number of immigrants and the number of emigrants. Positive net migration occurs if the immigrants outnumber the emigrants. It is negative if the number of immigrants is less than the number of emigrants. Positive net migration of working-age individuals would increase the number of workers and entrepreneurs.
An increase in the production of capital goods would increase the net investment in fixed assets such as equipment, machinery and factory building. Net investment is the value of capital assets less capital consumption or depreciation. Government spending on infrastructure such as railways, roads and electricity, will contribute to increasing the LRAS.
The discovery of more natural resources will increase their availability in production. More land would increase the availability of raw materials. Besides, finding new uses for existing resources is tantamount to having more resources. For example, wilderness or oceans can be converted for agricultural or industrial use.
Raising the retirement age or reducing the school entry age
The government can delay retirement by raising the retirement age in the country. This will make more people available for work. In addition, reducing the school entry age makes it possible for students to gain admission at an early age, complete their education early and join the labour force.
Privatisation and deregulation
Privatisation increases the number of entrepreneurs as private individuals buy up businesses formally owned by the government. Also, deregulation attracts more entrepreneurs; the economy’s productive capacity will expand as a result.
Natural population increase
The population will increase if the birth rate exceeds the death rate. This is known as natural population increase. The number of workers and entrepreneurs would rise also.
B. Increase in the quality of resources
Education and training
Education and training will improve the productivity of labour and entrepreneurship. New skills are acquired which improve the efficiency of firms and raise output in the economy.
Technological advancement has contributed to improvement in the productivity of capital; it can help create more efficient machine and production processes which improve an economy’s output. Technology can also improve the productivity of labour, land and enterprise. This is why companies and governments devote large sums to Research and Development (R&D) to bring about technological breakthroughs and innovations.
Improvement of the fertility of land
More yields can be obtained from agricultural land through irrigation and fertilisers. More output can even be obtained from a small amount of land with the use of irrigation and fertilisers.
Benefits of economic growth
Creation of employment opportunities
There is an increase in the total output of the economy as a result of economic growth. Therefore, more people are needed for productive purposes. Employed people have the incomes to increase their consumption and satisfy their numerous wants, thereby raising their living standards.
More goods available for local consumption
A rise in GDP increases the amount and variety of goods and services available for domestic consumption. This is expected to improve people’s standard of living.
Growth in domestic output would encourage the exportation of surplus products to markets abroad. This is an avenue for firms to broaden their revenue base. In addition, there will be an increase in tax revenue for the government from export duties and profit taxes from exporting firms. A current account deficit can also be reduced if exports outstrip imports.
More revenue for the government
More people working means more taxes to the government from both income and Value Added Tax (VAT). This will reduce budget deficit and the need to borrow to finance government expenditure. Government can redistribute income from taxes and provide benefits to the poor. It can afford to provide more public services such as education, hospitals, roads, etc.
Attraction of investors
A country with a record of continuous economic growth will always attract investors as business confidence will be high. A rising output implies that people have more income; therefore, high expected sales would encourage more investments from both domestic and foreign investors.
Costs of economic growth
If an economy has fully utilised its resources, economic growth can lead to the build-up of inflationary pressure. Rising income may lead to a rapid increase in aggregate demand. This may cause demand-pull inflation.
Depletion of non-renewable resources and pollution
Economic growth requires the use of more resources. Using up resources makes less available in the future when they may be more valuable if conserved. Also, productive activities contribute to global warming through air pollution. Pollution worsens people’s health and productivity.
Destruction of wildlife habitats
Economic growth requires more land for factory buildings which has led to the destruction of wildlife habitats. This has also reduced the tourism potential of the economy.
Structural changes may lead to unemployment
There may be changes in production and the requirement for different kinds of skills. People could be made redundant and unemployed unless they learn new skills.
Economic growth has an opportunity cost
In order to increase its potential growth, a country may have to produce more capital goods at the expense of consumer goods. Fewer resources would be available for producing consumer goods, thereby reducing the standard of living in the short run.
Economic growth is accompanied by rising incomes which would increase import expenditure. A current account deficit may result if imports outweigh exports.
It is not everyone that benefits from economic growth. Wealthy households tend to benefit more than poor households. The rich may possess assets that give them more income while the poor may not even have the relevant skills to be gainfully employed. This widens the gap between the rich and the poor.