How economic growth may be caused by an increase in total demand, an increase in the quantity of resources or an increase in the quality of resources

Government and the Macro‑economy – Economic Growth

Learning Objective

Explain how economic growth may be caused by:

  1. An increase in total (aggregate) demand.

  2. An increase in the quantity of resources (factor inputs).

  3. An increase in the quality of resources (productivity improvements).

1. What is Economic Growth?

  • Cambridge definition (4.5.1): A sustained increase in a country’s real output, measured by real Gross Domestic Product (real GDP), over a period of time.

  • It is a long‑run concept – the economy’s capacity to produce goods and services expands.

2. Measuring Economic Growth (4.5.2)

ConceptExplanation / Formula
Real GDPNominal GDP adjusted for changes in the price level (inflation).

Real GDP = Nominal GDP ÷ (Price Index ÷ 100)

Growth rate of real GDP

\[

\text{Growth rate (\%)}=

\frac{\text{Real GDP}{t}-\text{Real GDP}{t-1}}

{\text{Real GDP}_{t-1}}\times100

\]

Per‑capita real GDPReal GDP ÷ population. Indicates whether the average standard of living is rising.
Long‑run vs short‑run growth

  • Long‑run growth = outward shift of potential output (LRAS or PPF).

  • Short‑run growth = movement along a fixed LRAS caused by a change in aggregate demand; may be temporary and can generate inflation.

3. Causes of Economic Growth

3.1 Increase in Total (Aggregate) Demand (4.5.3)

When total demand for goods and services rises, firms increase output to meet the higher spending. If the higher demand is sustained, firms are likely to invest in more capacity, shifting potential output outward – a source of long‑run growth.

Key demand‑side drivers

  • Consumer confidence – higher willingness to spend → ↑ consumption (C).

  • Expansionary fiscal policy – ↑ government spending (G) or ↓ taxes → ↑ disposable income.

  • Monetary stimulus – lower interest rates → ↑ investment (I) and house‑buying.

  • Export growth – ↑ foreign demand → ↑ net exports (X‑M).

Diagram – AD‑AS

AD‑AS diagram showing AD shift right (A→B) and subsequent LRAS shift right (B→C)

AD‑AS model: a right‑ward shift of Aggregate Demand (AD) moves the equilibrium from point A to B, raising real GDP and the price level in the short run. If firms expand capacity, LRAS (or the PPF) also shifts right to point C, showing long‑run growth.

Short‑run vs long‑run effects

  • Short‑run: Output ↑, price level ↑ (possible inflation).

  • Long‑run (sustained demand): Firms invest, LRAS shifts right → potential output ↑, price level stabilises.

3.2 Increase in the Quantity of Resources (Factor Inputs) (4.5.4)

More factor inputs enlarge the Production Possibility Frontier (PPF); the economy can produce more even if productivity stays unchanged.

Four main resources and how their quantity can rise

ResourceHow quantity can increaseGrowth effect
Labour (L)Population growth, immigration, higher labour‑force participation, later retirementMore workers → higher potential output
Capital (K)Savings, foreign direct investment, government infrastructure programmes, private investmentMore machines, factories, roads → greater productive capacity
Land (T)Acquisition of new land, reclamation, better utilisation of existing landMore space for agriculture, industry, services
Entrepreneurship (E)Start‑up incentives, reduced red‑tape, access to finance, business‑friendly regulationsMore firms and innovations → higher output

Production‑function representation

\[

Y = F(K,\;L,\;T,\;E)

\]

Holding other inputs constant, an increase in any one input raises \(Y\).

Diagram – PPF outward shift

PPF diagram showing outward shift because of more labour or capital

Outward shift of the PPF when the quantity of one or more resources increases (e.g., a larger labour force). The new frontier represents a higher level of potential output.

3.3 Increase in the Quality of Resources (Productivity Improvements) (4.5.5)

Quality improvements raise the amount of output that can be produced from a given set of inputs – the production function shifts upward.

Ways quality can improve

  • Human capital development – better education, vocational training, health care.

  • Technological progress – new machinery, software, production techniques, R&D breakthroughs.

  • Better organisation – modern management, economies of scale, improved logistics.

  • Environmental sustainability – greener technologies and resource‑efficient processes that raise long‑run productivity.

Production‑function illustration

\[

Y = F(K,\;L,\;T,\;E)\;\;\longrightarrow\;\;Y' = F'(K,\;L,\;T,\;E)\quad\text{with}\;F' > F

\]

Diagram – PPF upward shift due to productivity

PPF diagram showing outward shift with same resource quantities

Outward shift of the PPF when productivity rises, even though the quantity of resources is unchanged.

4. Interaction of the Three Causes

In practice the three sources of growth often reinforce each other.

  1. Fiscal stimulus – ↑ public spending raises aggregate demand.

  2. The same spending is directed at infrastructure projects, adding to the capital stock (quantity of resources).

  3. A portion of the budget funds research and development, leading to technological progress (quality of resources).

The combined effect can shift both AD and the LRAS/PPF outward, producing sustained growth.

5. Recession – the opposite of demand‑side growth (4.5.4)

A recession occurs when total demand falls, causing output to drop below potential and the price level to fall or stagnate. It highlights why demand‑side growth must be matched by supply‑side improvements to avoid inflationary pressures when the economy recovers.

6. Policies to Promote Economic Growth (4.5.5)

6.1 Demand‑side (expansionary) policies

PolicyMechanismLink to growth cause
Expansionary fiscal policy (↑ G or ↓ taxes)Raises disposable income and consumption, shifting AD right.Increase in total demand.
Monetary stimulus (↓ interest rates, quantitative easing)Reduces borrowing costs → ↑ investment and house‑buying, also raises AD.Increase in total demand.

6.2 Supply‑side policies

These aim to increase the quantity or quality of resources, moving LRAS/PPF outward.

PolicyTargetGrowth effect
Infrastructure spendingMore capital (K)Quantity of resources ↑ → LRAS shifts right.
Education & training programmesHuman capital (L) – qualityProductivity ↑ → LRAS shifts right.
Research & development subsidiesTechnological progress (quality)Productivity ↑ → LRAS shifts right.
Deregulation & tax incentives for start‑upsEntrepreneurship (E) – quantity & qualityMore firms, better organisation → LRAS shifts right.
Environmental / green‑technology programmesSustainable use of land & resourcesLong‑run productivity ↑, reduces future resource constraints.

6.3 Mixed‑economy considerations (optional for exam)

Market failures (e.g., under‑investment in R&D, externalities) justify government intervention. Supply‑side policies often address these failures, ensuring that the private sector can contribute to growth without creating negative spill‑overs.

7. Summary Checklist (Exam‑style)

  • Identify whether the change is demand‑side (AD) or supply‑side (LRAS/PPF).

  • State which resource(s) are affected – quantity (more workers, machines, land, firms) or quality (better skills, technology, organisation, sustainability).

  • Explain the short‑run impact (output & price level) and the long‑run impact (potential output).

  • Use the appropriate diagram: AD‑AS for demand‑side, LRAS/PPF for supply‑side, or a production‑function graph for productivity.

  • Link any policy mentioned to the relevant cause of growth.

Key Terms (Cambridge)

TermDefinition
Economic growthSustained increase in a country’s real GDP over time.
Real GDPNominal GDP adjusted for changes in the price level.
Aggregate demand (AD)Total demand for goods and services at a given overall price level.
Aggregate supply (AS)Total output firms are willing to produce at a given overall price level.
Long‑run aggregate supply (LRAS)Vertical supply curve representing the economy’s potential output.
Production Possibility Frontier (PPF)Graph showing the maximum combinations of two goods that can be produced with existing resources and technology.
ProductivityOutput per unit of input (e.g., per worker or per hour of labour).
Human capitalSkills, knowledge, health and experience that workers possess.
Technological progressInnovation that enables more output from the same amount of inputs.
Per‑capita GDPReal GDP divided by the population; measures average standard of living.
RecessionA period of falling output and demand, usually defined as two consecutive quarters of negative GDP growth.
Supply‑side policyGovernment actions that increase the quantity or quality of resources, shifting LRAS/PPF outward.

Practice Questions

  1. Explain how a reduction in interest rates can lead to economic growth through the demand side. Include short‑run and long‑run effects and illustrate with an AD‑AS diagram.

  2. Using the production function \(Y = F(K,L)\), illustrate the effect of a 10 % increase in the capital stock while labour and technology remain unchanged. State what happens to potential output.

  3. Discuss two ways in which improvements in education can raise the quality of resources and thereby promote economic growth.

  4. Analyse a scenario where a country experiences a large rise in consumer confidence but no change in the quantity or quality of resources. What are the likely short‑run and long‑run outcomes?

  5. Identify and evaluate one demand‑side and one supply‑side policy that a government could use to sustain growth. Link each policy to the relevant cause of growth.