Economic Growth

Types of economic growth

There are two types of economic growth are:

• short-run economic growth
• long-run economic growth.

Short-run economic growth

Short-run economic growth is when the economy uses spare capacity in order to increase the real output. Spare capacity occurs when the economy's productive potential is underutilised. In other words, either not all resources are utilised or not utilised efficiently. Figure 1 shows the short-run economic growth by the movements of real GDP (Y) and the price level (P) when the aggregate demand (AD) increases.

Fig. 1 - Short-Run Economic Growth

When AD increases (from AD1 to AD2), the real GDP increases (from Y1 to Y2) causing a significant rise in the price level (from P1 to P2).

Aggregate supply (AS) is the total value of goods and services produced in the economy over a particular time. Whereas aggregate demand (AD) is the total amount of money spent on goods and services produced in the economy over a particular time.

Long-run economic growth

Long-run economic growth is an increase in the economy's productive capacity due to an increase in the long-run aggregate supply. It means that the potential or trend economic growth rate is higher. Figure 2 shows the long-run economic growth by the movements of real GDP (Y) and the price level (P).

Fig. 2 - Long-Run Economic Growth

When LRAS increases, the real GDP increases (from Y1 to Y2), causing a significant fall in price level (from P1 to P2).

It is also worth looking at a PPF diagram.

Fig. 3 - Economic Growth PPF

Short-run economic growth is a movement from inside PPF1 to a point on PPF1 (A to B). Long-run economic growth is an outward shift of PPF (B to C). The inward shift of the PPF is similar to the LRAS curve shifting to the left. The outward shift of the PPF is similar to the LRAS curve shifting to the right.

To learn more about the PPF check out our explanation on Production Possibility Curves.

Causes of economic growth

At the core of economic growth is the increase in productivity, which is the efficiency with which inputs (like labor and capital) are used to produce goods and services. Several interconnected factors typically drive this productivity growth, each contributing to the ability of an economy to produce more output from the same amount of input. Here, we delve into some of these primary causes of economic growth.

Investment in Physical Capital

Physical capital, such as machinery, buildings, and infrastructure, is a crucial driver of economic growth. Investing in new factories, equipment, or technology increases their production capacity and allows them to produce more goods and services. For example, constructing new highways and railways in India has boosted the country's economic growth by improving connectivity and facilitating the movement of goods and people.

Human Capital Development

Human capital refers to the skills, knowledge, and experience an individual or population possesses. Investment in education, training, and healthcare can lead to a more productive workforce, thereby driving economic growth. For instance, South Korea's emphasis on education and skills training has been a significant factor behind its transformation from a developing to a developed economy within a few decades.

Technological Progress

Technological progress can greatly enhance economic growth by improving efficiency and creating new opportunities for businesses. For example, the advent of the internet has revolutionized industries worldwide and significantly contributed to global economic growth.

Economic growth examples

The global economic landscape is dotted with stories of countries that have achieved significant economic growth over different periods. These examples showcase nations' various paths and strategies to expand their economies. Here, we explore economic growth in the United Kingdom, China, and Rwanda, each offering unique insights into this complex process.

United Kingdom's Economic Growth

The United Kingdom experienced significant economic growth during the Industrial Revolution in the late 18th and early 19th centuries. This was primarily due to advancements in technology and the expansion of factories, leading to a dramatic increase in productivity. The UK's economic growth continued in the post-WWII era, fueled by the growth of the service sector, particularly finance and business services.

More recently, in 2022, UK GDP growth was reported at 4.1%, comparing the whole year's GDP with that of 2021. This relatively strong rate of growth in 2022 was primarily a result of the continued recovery from the pandemic-related economic weakness experienced in early 2021.¹

China's Economic Growth

Since China began to open up and reform its economy in 1978, it has experienced extraordinary economic growth. The country's GDP growth has averaged over 9 percent a year, lifting more than 800 million people out of poverty and significantly improving access to health, education, and other services.

China's economic model was largely based on investment, low-cost manufacturing, and exports, but it has reached its limits and caused economic, social, and environmental imbalances. Hence, a shift in the structure of the economy is required, moving from manufacturing to high-value services, from investment to consumption, and from high to low carbon intensity.

However, in recent years, growth has moderated due to structural constraints, including declining labor force growth, diminishing returns to investment, and slowing productivity growth. The challenge going forward is to find new drivers of growth while addressing the social and environmental legacies of China’s previous development path.²

Rwanda's Economic Growth

Rwanda's economic recovery since the 1994 genocide has been remarkable. The country's Gross Domestic Product (GDP) rose from $752 million in 1994 to $9.5 billion in 2018. Focused on creating a knowledge-based economy, the government invested heavily in information and communication technology and services sector. Coupled with political stability, these efforts have resulted in consistent GDP growth, averaging around 7-8% per year in the past decade, with a double-digit growth recorded in the last two quarters of 2019 (12% growth in the 2nd quarter, and 11.9% in the 3rd quarter).

The sustained economic growth has led to one million people being lifted out of poverty (between 2000 and 2017) while life expectancy has risen from 29 years in 1994 to 67 years in 2016.³

Shifts of aggregate demand and aggregate supply and economic growth

Let’s study how the shifts of aggregate demand and supply are related to economic growth.

Shifts of aggregate demand

Changes in aggregate demand relate to a demand-side influence on an economy. This means that any changes in the components of aggregate demand cause a shift in the position of the AD curve.

\(AD=C+I+G+(X-M)\)

If there is an increase in consumption, investment, government spending, or net export demand, the AD curve shifts to the right (see figure 4).

Fig. 4 - Shifts of Aggregate Demand

What happens next depends on the aggregate supply curve. You can see the SRAS (short-run aggregate supply) curve moving from very low to very high levels of real income crossing a vertical LRAS curve.

When a level of real output is below the full capacity level of output (Y5), AD shifts from AD1 to AD2 increasing the real output (Y1 to Y2), but not the price level (P1). A reason for that is the spare capacity in an economy. When an economy has plenty of spare capacity the aggregate demand can increase without creating inflationary pressures.

Nevertheless, when output increases, the SRAS curve gradually slopes upwards. Now both aggregate demand and prices increase (AD3 to AD4 and P2 to P3) causing higher rates of inflation.

When the economy is at full capacity (on the LRAS curve at Y5), an increase in aggregate demand will be purely inflationary.

Shifts of aggregate supply

Changes in aggregate supply relate to a supply-side influence on an economy. If real output reaches its full capacity, long-run economic growth requires the LRAS curve to shift to the right like in figure 5.

Fig. 5 - Shifts of Aggregate Supply

The long-run aggregate supply moves from LRAS1 to LRAS2, causing the output level to move from Y1 to Y2.

Long-run economic growth allows an economy to grow sustainably. The trend growth rate (or potential growth rate) is a rate at which output can grow sustainably.

Benefits and costs of economic growth

Although economic growth seems entirely positive, it has benefits and costs. Let’s see the main ones.

Sustainable economic growth

Economic growth is often associated with the excessive use of non-renewable natural resources. Moreover, economic growth tends to contribute to environmental pollution which is caused by increased output and waste.

Economic growth is also associated with sharp price increases and imbalances in terms of labour exploitation and social inequalities. That is why to maximise the benefits and reduce the costs of economic growth, it needs to be sustainable.

Sustainable economic growth includes two main elements:

• Environment: sustaining natural resources and protecting the environment.
• Economy: keeping inflation low and finding a balance between the different forces and pressures.