Revise Economic growth for Cambridge 2281 (4.6)

Economic growth signifies an increase in the productive capacity of an economy over time, most commonly measured by the percentage change in real Gross Domestic Product (GDP). It is crucial to distinguish between nominal GDP, which measures output at current market prices, and real GDP, which is adjusted for inflation. Real GDP provides a more accurate measure of economic performance because it reflects the actual volume of goods and services produced, stripping out the effects of price changes. To calculate it, economists use a price index like the GDP deflator to adjust nominal GDP figures relative to a chosen base year. This allows for a meaningful comparison of economic output and living standards across different time periods.

It is essential to differentiate between actual and potential growth. Actual growth is the measured rate of increase in real GDP in a given period. On a Production Possibility Curve (PPC) diagram, it is shown by a movement of a point from within the curve towards its boundary, indicating the utilisation of previously unemployed resources. Potential growth, in contrast, refers to the increase in the economy's maximum possible output. This is represented by an outward shift of the entire PPC or a rightward shift of the Long-Run Aggregate Supply (LRAS) curve. Potential growth is determined by an increase in the quantity or an improvement in the quality of factors of production, reflecting a rise in the economy's productive capacity.

Long-run economic growth, or the expansion of potential output, is fundamentally driven by factors that shift the LRAS curve to the right. These are supply-side factors that enhance the economy's productive capacity. Key drivers include an increase in the quantity of factors of production, such as a larger labour force through immigration or a higher capital stock from investment. Equally, improvements in the quality of factors are vital; this includes a more skilled and educated workforce (human capital), technological advancements, and innovation that boosts productivity. A stable institutional framework, including secure property rights and efficient legal systems, also encourages the investment and risk-taking necessary for sustained long-run growth.

Sustainable economic growth is a rate of growth that can be maintained in the long run without creating significant economic and social problems for future generations. This concept has two main dimensions. Firstly, it implies macroeconomic stability: growth that does not generate accelerating inflation, an unmanageable balance of payments deficit, or excessive inequality. Secondly, it refers to environmental sustainability: achieving growth without causing the depletion of non-renewable resources or irreversible environmental damage, such as climate change and loss of biodiversity. The core challenge for policymakers is to foster growth that raises current living standards while preserving the capital—natural, human, and physical—that future generations will need.

Actual growth occurs when AD increases and the economy produces more this year than last — this may be cyclical (recovery from recession) or unsustainable (above Yf).

Potential growth increases Yf — the economy's productive capacity expands through more resources, better technology, and higher productivity.

Real GDP growth rate = $\frac{\text{Real GDP}_1 - \text{Real GDP}_0}{\text{Real GDP}_0} \times 100$

Output gap = Actual Y − Potential Yf

Positive gap: inflationary | Negative gap: recessionary