actual growth versus potential growth in national output

Economic Growth and Sustainability (Cambridge AS & A Level 9708)

Learning objective

Explain the difference between actual growth and potential growth in national output, analyse the causes of any output gap and evaluate the implications for sustainable, inclusive development.

Key concepts

• Actual growth: realised increase in real GDP over a period.
  Formula: g_actual = (Y_t − Y_t‑1) / Y_t‑1
• Potential growth: the maximum sustainable increase in real GDP that can be achieved without generating inflationary pressure, given the economy’s stock of labour, capital, technology and institutions.
• Output gap: the difference between actual and potential output.
  ΔY = Y_actual − Y_potential
  • Positive gap (ΔY > 0): actual > potential → upward pressure on the price level (inflation).
  • Negative gap (ΔY < 0): actual < potential → idle resources and higher unemployment.
• Sustainability: the ability to maintain growth over the long term without depleting natural resources, causing irreversible environmental damage or creating unacceptable social inequality.
• Inclusive growth: growth that is broad‑based, reduces poverty and inequality and improves the standard of living for all sections of society.

Determinants of potential growth (Cambridge Topic 9.2)

1. Growth of the labour force – population growth and labour‑force participation rates. (Links to the syllabus key concept *efficiency* – a larger, more active labour force raises the productive capacity of the economy.)
2. Human‑capital accumulation – education, health, on‑the‑job training and skill formation. (Key concept *progress & development* – higher human capital improves productivity.)
3. Physical‑capital formation – investment in machinery, plant, infrastructure and housing. (Key concept *efficiency* – more capital per worker raises output per hour.)
4. Technological progress – innovation, research & development, and diffusion of existing technologies. (Key concept *efficiency* – raises total factor productivity.)
5. Institutional quality – property rights, rule of law, regulatory environment and governance. (Key concept *progress & development* – good institutions encourage investment and efficient resource allocation.)

Production‑function side‑box

Output‑gap analysis using the AD/AS framework (Cambridge Topic 9.3)

• Long‑run aggregate supply (LRAS) represents potential output (Y_potential); it is vertical at the full‑employment level of output.
• Short‑run aggregate supply (SRAS) and aggregate demand (AD) intersect at the actual level of output (Y_actual) and the prevailing price level (P).
• A negative output gap occurs when AD lies to the left of LRAS (Y_actual < Y_potential), producing downward pressure on P and higher unemployment.
• A positive output gap occurs when AD is to the right of LRAS (Y_actual > Y_potential), creating upward pressure on P (inflation) and labour‑market tightness.

The multiplier and fiscal policy (Cambridge Topic 9.1)

The expenditure multiplier shows how an initial change in autonomous spending (ΔA) is magnified through successive rounds of consumption:

ΔY = \frac{1}{1‑MPC}\;·\;ΔA = k·ΔA

In the AD/AS model a fiscal expansion of size ΔG (or ΔC) moves the AD curve rightward by exactly the multiplier‑generated change in output (ΔY = k·ΔG). The effect on the output gap depends on whether the economy is below or at potential:

• If a negative gap exists, the rightward AD shift reduces the gap and lowers unemployment.
• If the economy is already at or above potential, the same shift widens a positive gap and fuels inflation.

Why actual growth may diverge from potential growth

Short‑run fluctuations in demand, supply shocks and policy actions can create an output gap.

• Demand‑side factors: consumer confidence, fiscal stimulus, monetary policy, exchange‑rate movements that affect export demand.
• Supply‑side shocks: oil‑price spikes, natural disasters, pandemics, abrupt changes in productivity.
• Policy mis‑alignment: over‑expansionary fiscal/monetary policy can push the economy beyond its potential; overly tight policy can leave it below potential.

Employment, unemployment and the output gap

• A negative output gap usually coincides with cyclical unemployment (actual unemployment > natural rate) because firms use fewer workers than they would at full capacity.
• A prolonged negative gap can lead to hysteresis: skills erosion and labour‑market detachment that raise the natural rate of unemployment even after the gap closes.
• A positive output gap pushes unemployment below the natural rate, creating upward pressure on wages and prices.

Money, banking and monetary policy

Monetary policy influences the output gap mainly through the interest‑rate and credit channels:

• Interest‑rate channel: a lower policy rate reduces borrowing costs, stimulates investment (I) and consumption (C), shifting AD rightward.
• Money‑supply channel: an expansion of the money supply (M) lowers interest rates (LM curve shifts right) and raises AD.
• When inflationary pressures arise from a positive output gap, the central bank may raise rates to cool demand; when a negative gap persists, it may cut rates or use quantitative easing.

Government macro‑policy tools (Cambridge Topics 5, 10)

International context (Cambridge Topics 6, 11)

• External demand: a rise in world demand for a country’s exports shifts AD rightward, potentially creating a positive output gap.
• Exchange‑rate movements:
  • Depreciation makes exports cheaper and imports more expensive → net exports (NX) rise → AD shifts right.
  • Appreciation has the opposite effect.
  • Policy implication: under a flexible‑exchange‑rate regime the exchange rate can act as an automatic stabiliser; under a fixed regime the government may need to intervene (e.g., via fiscal policy) to close the gap.
• Balance‑of‑payments (current‑account) components:
  Current account = (Exports − Imports) + Primary income + Secondary income.
  A large current‑account deficit can force a country to tighten fiscal or monetary policy, widening a negative output gap.
• Growth traps in developing economies: low‑skill labour, weak institutions and limited access to technology keep potential growth low. International assistance, technology transfer and foreign direct investment are often required to break the trap and achieve sustainable development.

Comparative table: Actual vs. Potential growth

Assessing the sustainability of growth (Cambridge Topics 9.2 & 9.3)

Four dimensions must be satisfied for growth to be deemed sustainable:

1. Economic dimension: The output gap remains small; actual growth does not consistently exceed potential growth, avoiding persistent inflation.
2. Social (inclusive) dimension: Poverty and inequality fall. Typical indicators are:
   • Gini coefficient (declining trend)
   • Poverty head‑count ratio (percentage below the poverty line)
   • Real wage growth for low‑income workers
3. Environmental dimension: Resource use stays within regenerative capacity; carbon intensity (CO₂ per unit of GDP) declines; policies promote renewable energy, energy‑efficiency and circular‑economy practices.
4. Institutional dimension: Strong governance, secure property rights and transparent regulation support long‑run investment and prevent “growth‑at‑any‑cost” externalities.

Illustrative diagram (suggested)

Exam‑style questions

1. Define actual growth, potential growth and the output gap. Explain why a positive output gap can lead to inflation.
2. Using the production function Y = A K^α L^1‑α, show mathematically how an increase in total factor productivity A affects potential growth.
3. Discuss two supply‑side policies that can raise potential growth while contributing to environmental sustainability.
4. Explain how a depreciation of the domestic currency can help close a negative output gap in a small open economy. Include possible trade‑offs for inflation and external debt.
5. Evaluate the extent to which a fiscal stimulus aimed at reducing unemployment can be compatible with the goal of inclusive, sustainable growth.

Summary

Actual growth reflects the short‑run performance of an economy, whereas potential growth captures the long‑run capacity to expand output without triggering inflation. The output gap measures the distance between the two and signals whether demand‑side (fiscal/monetary) or supply‑side (structural) policies are required. Sustainable growth demands that the gap stay small, that potential growth be continually enhanced through investment in labour, capital, technology and institutions, and that the benefits of expansion be shared (inclusive) and environmentally responsible. Policymakers must therefore balance short‑run stabilisation with long‑run structural reforms, both domestically and in the global context.