2.5 Economic Growth

Question 1

Factors which could cause economic growth

Answer 1

• increase in components of AD (consumer spending, investment, gov spending, net trade)

Question 2

Short run (actual) economic growth explained on graphs

Answer 2

• PPF curve
  (increase in economic growth moves economy closer to full unemployment (outer line) = increase in amount of goods services produced in economy = movement further towards PPF curve (but PPF curve doesn’t move)
• aggregate supply/demand diagram
  (Increase in components of AD shifts AD to the right (AD1 to AD2) = increase in price level (P1 to P2) & increase in real GDP (Y1 to Y2) = economy moves closer to full employment (YFE)

Question 3

What causes long run economic growth

Answer 3

= increase in quantity / quality of factors of production within economy

Question 4

Long run economic growth explained on graphs

Answer 4

• PPF curve

(Productive potential of economy shifts outwards from A to B = total amount of consumer & capital goods produced increases) = outward shift of PPF curve

• AD/AS diagram

(Increase in quantity/quality of factors of production = LRAS increases (LRAS1 to LRAS2) = increase in real GDP (Y1 to Y2)
Increase in productive capacity of economy from Y1 to YFE, new level of full employment
But economy operating at Y2 = slightly below full employment = spare capacity in economy = reduced pressure on existing factors or production = price level decreased (P1 to P2)

Question 5

Distinction between actual & potential economic growth

Answer 5

Actual growth: increase in real GDP = results in increase of price level (increase in AD = more pressure on existing factors of production)

Potential growth: increase in productive capacity of economy (maximum possible output) = results in decrease in price level (AD remains same, but more goods/serviced produced = less pressure on existing factors of production)

Question 6

Importance of international trade for (export-led) economic growth (why might this be a problem)

Answer 6

Some countries (china) achieve large proportion of economic growth from exports (current account surplus from net trade of goods/services), only possible with international trade (due to comparative advantage = country able to produce good/service at lower opportunity cost than other countries)

state of other countries’ economies has big impact on countries with export led economic growth (recession in countries which are main trading partners with domestic country can massively reduce the demand for domestic exports = big impact on domestic economic growth)

Question 7

Actual economic growth rates

Answer 7

= measured by changes in real GDP over time

Often volatile (various booms & recessions)

Question 8

Long term trends in growth rates

Answer 8

= average sustainable rate of growth over a period of time (without regular fluctuations), determined by changes in productive capacity of economy

Question 9

How to compare actual growth rates and long term trends in growth rates (with graph)

Answer 9

• actual growth rate above trend growth rate = positive output gap (sometimes a boom)

In this period there will be high levels of inflation due to lots of pressure on existing factors of production, caused by the economy operating past the level of full employment

• actual growth rate below trend growth rate = negative output gap (sometimes a recession)
  In this period there will be low inflation due to little pressure on existing factors of production , caused by the economy operating below full employment

Question 10

The output gap

Answer 10

= difference between the actual level of real GDP and maximum potential level of real GDP

Question 11

Negative output gap (definition & characteristics)

Answer 11

= actual level of real GDP is less than maximum potential level of real GDP

(spare capacity within economy)

Likely to be low inflation & high levels of unemployment

Question 12

Positive output gap (definition & characteristics)

Answer 12

= actual level of real GDP is greater than maximum potential level of real GDP

Likely to be high inflation & low levels of unemployment

Question 13

Why is it difficult to measure / estimate the size of the output gap of an economy

Answer 13

need to estimate economy’s maximum potential output level - many different variables make this difficult (changes in quantity of labour, productivity/quality of workforce, spare capacity of individual businesses) = data could be inaccurate & knowledge gaps = figure for maximum potential output of economy likely to be a very rough estimate

Question 14

Using a classical AD/AS diagram to show a negative output gap

Answer 14

Current output at Y1, price level at P1
Full employment output of economy at YFE

Output of YFE greater than Y1 = negative output gap within economy (spare capacity is difference between Y1 & YFE)

Question 15

Using a classical AD/AS diagram to show a positive output gap

Answer 15

Current output at Y1, price level at P1
Full employment output at YFE

Output at YFE is less than output at Y1 = positive output gap within economy (able to operate past full employee point by using existing factors of production unsustainably)

Question 16

Why are positive output gaps unsustainable in the long run according to the classical model of AS/AD

Answer 16

Workers will increase their wages in long run = causes SRAS to decrease = economy moves back to full unemployment

(factors of production used unsustainably, will eventually have to stop)

Question 17

Using a Keynesian AD/AS diagram to show a negative output gap

Answer 17

Current output at Y1, current price level at P1
Full employment level at YFE

Output at YFE is greater than output at Y1 = negative output gap

(spare capacity in economy = difference between Y1 & YFE)

Question 18

Why cant a positive output gap be shown on a Keynesian AS/AD diagram

Answer 18

Keynesian model only has one AS line = economy can’t operate at short run equilibrium past the full employment point

Question 19

Trade (business cycle)

Definition, characteristics, graph

Answer 19

Demonstrates recurring trends in economic growth that economies often experience (shows fluctuations of actual economic growth following trend growth of economy)

• boom
• slowdown
• recession
• recovery…

Question 20

Characteristics of a boom

Answer 20

• high rates of economic growth (lots of consumer spending / investment = large increase in AD)
• low rates of unemployment (increase in AS & high economic growth = equilibrium moves closer to, at, or past full employment (YFE))
• demand-pull inflation (economy moves closer to full capacity = increase on pressure on existing factors of production to keep up with increase in AD = increase in general price level)
• higher consumer/business confidence (rising incomes, rising house prices, job stability, positive outlook on economy, more consumer spending)
• improving gov budget balance (less unemployment = less welfare spending & increase in tax revenue (VAT, income tax))

Question 21

Characteristics of a recession

Answer 21

• negative rates of economic growth (decrease in consumer spending / investment = decrease in AD = decrease in real GDP)
• high rates of unemployment (decrease in AD = fall in real GDP = fall in demand for goods therefore labour = cyclical/demand-deficient unemployment)
• low rate of inflation (decrease in real GDP = lots of spare capacity = less pressure on existing factors of production = fall in prices level of goods/services)
• low business / consumer confidence (reduction in job security, fall in house prices, negative outlook on economy = increase in savings (MPW) = decrease in consumer spending, more business closures, economic uncertainty = decrease in investment)
• worsening of gov budget balance (unemployment rises = more gov welfare spending & less income tax/VAT/corporation tax = tax revenue decreases & gov spending increases)

Question 22

Benefits & costs of economic growth to consumers

Answer 22

+ consumer income (firms need to attract workers by offering higher wages as less people unemployed)

+ reduction in unemployment (increase in AD causes increase in real GDP = reduces spare capacity in economy, moves towards full employment, cyclical unemployment decreases, demand for labour derives from AD increase)

• high cost of living / high inflation (increase in AD = increase in price level = pressure on factors of production = decrease in purchasing power)

Question 23

Benefits & costs of economic growth to firms

Answer 23

+ increased revenues & profits (increase in AD (consumer spending) = increase in firms profit/revenue)

+ increased investment (increase in business confidence & profits = more firm investment = increased efficiency/productivity)

• decrease in amount of labour to choose from (unemployment decreases = less people looking for work = harder to fill jobs = firms may have to offer higher wages)
• menu costs (increase in inflation = firms may have to spend money changing prices (menu costs) of their good/service)

Question 24

Benefits & costs of economic growth to government

Answer 24

+ improvement in government budget balance (increase in consumer spending = increase in tax revenue (VAT/income tax/corporate tax) , reduction in unemployment = less gov welfare spending)

• worsening in current account of balance of payments (increase in demand as consumer incomes increase, but most goods/services from abroad = increase in import expenditure = trade deficit,(E: net trade only a small component of AD) )
• macroeconomic instability (high inflation = uncertainty for firms, consumers, investors = increase in volatility of economic growth (more booms and recessions in economic cycle)

Question 25

Benefits & costs of economic growth to current & future living standards

Answer 25

+ decrease in poverty rates (reduction in unemployment, increase in income)

+ higher standards of living (higher disposable income, less unemployment)

+ improvement in environment (increase in investment in efficient, cleaner tech, ( E: however only if firms decide to invest in this tech)

• negative impacts on environment (firms increase use of resources to increase output, some non-renewable & more pollution = increase in negative externalities)
• increase in relative income inequality (income increases may not be distributed equally, may be growth in some industries = increase in relative poverty)
• social effects of increased production (increase in AD = increase in pressure on existing factors of production = more stress & less leisure for workforce = decrease in happiness of population)