Macroeconomics guide, Unit 5, step 18 of 23Previous step Next step

Step 18: Economic Growth and Supply-Side Policy

By the EconTutorials team. 10-minute read with 6 practice questions.

SyllabusAP Macro 5.6–5.7 · Cambridge 4.4, 5.4, 9.2 · IB 3.7

In 30 seconds

Long-run economic growth means the economy can produce more: the PPC shifts outwards and the LRAS curve shifts right.
Living standards are best measured by growth in real GDP per capita, and the rule of 70 tells you how fast they double: years to double $ \approx 70 \div $ growth rate (%).
Growth comes from more and better physical capital, human capital, technology, natural resources and strong institutions, all of which raise productivity.
Supply-side policies try to speed this up. Market-based policies free up markets; interventionist policies use government spending. Exams reward you for evaluating both.

Video lesson coming soonA short animated lesson for this step will appear here.

What economic growth really means

Imagine a small bakery that can make 600 loaves a day. It buys a third oven and trains its bakers to work faster. Now it can make 900 loaves a day. Customers are no hungrier; what has changed is what the bakery is able to produce. Long-run economic growth is the same idea for the whole economy.

Economists draw this in two ways.

The production possibility curve (PPC) shows the combinations of two goods an economy can make with all its resources fully and efficiently used. Growth shifts the whole PPC outwards, away from the origin.
The long-run aggregate supply (LRAS) curve is vertical at full-employment (potential) output, $ Y_f $. Growth shifts LRAS to the right.

Do not confuse this with recovery from a recession. Putting unemployed workers back to work moves the economy from inside the PPC towards it; the curve itself has not moved.

Key termEconomic growth: a sustained increase in an economy’s productive capacity, shown by an outward shift of the PPC and a rightward shift of the LRAS curve.

DiagramDraw two graphs side by side. Left: a PPC with capital goods on the vertical axis and consumer goods on the horizontal axis. Draw the original bowed-out curve, then a second curve further out from the origin, and add an arrow showing the outward shift. Right: an AD–AS diagram with the price level on the vertical axis and real GDP on the horizontal axis. Draw a vertical LRAS$_1$ at $ Y_{f1} $, then LRAS$_2$ further right at $ Y_{f2} $. If AD also grows over time, the new equilibrium is at a higher real GDP. If AD stays the same, the new equilibrium is at higher real GDP and a lower price level.

Measuring growth: real GDP per capita and the rule of 70

GDP can rise just because more people live in a country. To see whether the typical person is better off, use real GDP per capita: real GDP (adjusted for inflation) divided by the population.

\[ \text{Real GDP per capita} = \frac{\text{Real GDP}}{\text{Population}} \]

A useful shortcut: the growth rate of real GDP per capita is roughly the growth rate of real GDP minus the growth rate of population.

Worked example

For example, a country’s real GDP rises from $500 billion to $525 billion in a year, while its population rises from 50 million to 51 million. By how much has real GDP per capita grown, and how long would living standards take to double at that rate?

Step 1$ \text{Old per capita} = \dfrac{500\,000\,000\,000}{50\,000\,000} = \$10\,000 $

Step 2$ \text{New per capita} = \dfrac{525\,000\,000\,000}{51\,000\,000} \approx \$10\,294.12 $

Step 3$ \text{Growth} = \dfrac{10\,294.12 – 10\,000}{10\,000} \times 100 \approx 2.94\% $

Step 4$ \text{Years to double} \approx \dfrac{70}{2.94} \approx 23.8 \text{ years} $

Real GDP grew by 5%, but because the population grew by 2%, income per person grew by only about 2.94% (close to the shortcut 5% − 2% = 3%). At that rate, average living standards would double in about 24 years.

\[ \text{Years to double} \approx \frac{70}{\text{annual growth rate (\%)}} \]

Small differences in growth rates matter enormously. At 1% a year, income doubles in about 70 years; at 3.5%, in about 20 years; at 7%, in about 10 years.

Where growth comes from

Go back to the bakery. It produced more because each baker could make more loaves per hour. That is productivity, and it is the engine of long-run growth.

Key termLabour productivity: output per worker (or per hour worked), calculated as real output divided by the number of workers or hours.

There are five main sources of growth. The first four raise productivity directly; the fifth creates the conditions for the others.

Source	What it means	Everyday example
Physical capital	Machines, tools, buildings and infrastructure used to produce goods and services	A café buys a second espresso machine
Human capital	The knowledge, skills and health of workers	A nurse completes extra training
Technology	Better ways of combining inputs to make output	A delivery firm uses route-planning software
Natural resources	Land, minerals, energy and water	A country discovers a new natural gas field
Institutions	Rule of law, secure property rights, low corruption, stable government	An entrepreneur invests because contracts are enforced by courts

Producing more capital goods today means giving up some consumer goods now, but it shifts the PPC further out in future. Technology is special: adding machines runs into diminishing returns, but new ideas can keep raising productivity.

Common mistakeWriting that an increase in aggregate demand (say, more government spending on wages) causes long-run economic growth. A rise in AD shifts the AD curve, not LRAS. It can raise output in the short run, but only an increase in the quantity or quality of resources, or better technology, shifts LRAS and the PPC. Spending causes growth only if it builds capacity, such as spending on schools, roads or research.

Supply-side policies: market-based and interventionist

Supply-side policies are government policies that aim to increase the productive capacity of the economy, shifting LRAS to the right. They are long-run policies; most take years to work. They come in two families.

Key termSupply-side policy: any government measure designed to raise productive capacity and productivity, shifting the LRAS curve to the right.

Market-based policies

These try to make markets work more freely so that firms and workers have stronger incentives.

Deregulation: removing rules that restrict competition or add needless costs, such as letting new airlines or taxi firms enter a market.
Tax cuts: lower income tax can increase the incentive to work; lower corporate tax can increase the incentive to invest.
Privatisation: selling state-owned firms to private owners, who have a profit motive to cut costs and improve quality.
Labour-market reform: making hiring easier, reducing the power of trade unions, or cutting unemployment benefits so that it pays more to take a job. Some economists include reducing or freezing minimum wages here.

Interventionist policies

These use government spending to fix gaps the market leaves.

Education and training: builds human capital, raising the skill and productivity of the workforce.
Infrastructure: roads, railways, ports, broadband and power grids cut firms’ costs and connect workers to jobs.
Research and development (R&D): grants, tax credits or state-funded research. Private firms under-invest in R&D because rivals can copy their ideas.

Evaluating each

Policy type	Strengths	Weaknesses
Market-based	Little or no direct cost to the government (privatisation even raises money); sharpens incentives and competition	Tax cuts may mostly benefit high earners and widen inequality; lower taxes may not increase effort much; deregulation can reduce safety or environmental standards; weaker labour protection can reduce job security
Interventionist	Fixes market failures (education and R&D have positive externalities); can reduce inequality and regional gaps	Expensive, so may need higher taxes or borrowing; long time lags (a schoolchild takes years to join the workforce); risk of government failure, such as building the wrong project

Two points apply to all supply-side policies. First, time lags: benefits come slowly, so they are poor tools against a recession. Second, many also affect AD: infrastructure spending raises AD now and LRAS later. The best answers notice both effects.

Exam tipAP Macro FRQ: when asked about long-run growth, draw the PPC shifting outward or LRAS shifting right, label the axes (“Real GDP” and “Price level”), label old and new curves, and state the cause (for example “more human capital raises productivity”). Do not shift AD unless asked. Cambridge 9708 and IB: evaluation earns the top bands. Say which policy, how it works step by step, then judge it: time lags, cost to the budget, effect on inequality, and whether the problem is really on the supply side. End with a justified conclusion (“it depends on…, but in an economy with low skills, education is likely to be more effective because…”).

Can growth last? Sustainability

Growth brings higher incomes and more tax revenue for public services, but it can also have costs:

Environmental damage: more production can mean more pollution, carbon emissions and loss of forests and wildlife.
Using up non-renewable resources: an economy that grows by pumping oil or mining metals is drawing down a stock that will run out.
Inequality: the gains from growth may go mainly to some groups or regions.

Sustainable growth meets the needs of the present without reducing the ability of future generations to meet their own needs. Governments pursue it through cleaner technology, carbon taxes, renewable energy and human capital, which does not run out. A country relying on one natural resource can also diversify into other industries so income does not collapse when the resource runs low.

Practise: 6 questions

Try each one on paper first, then check the worked answer.

EasyQ1. A country’s real GDP per capita grows at 3.5% a year. Using the rule of 70, roughly how long will it take to double? Show worked answer

Years to double $ \approx 70 \div 3.5 = 20 $ years.
So average living standards would double in about 20 years.

EasyQ2. Classify each policy as market-based or interventionist: (a) privatising the national airline, (b) building a new high-speed railway, (c) cutting the corporate tax rate, (d) funding apprenticeships. Show worked answer

(a) Market-based: transfers a firm to private ownership and the profit motive.
(b) Interventionist: government spending on infrastructure.
(c) Market-based: improves incentives to invest through lower tax.
(d) Interventionist: government spending on human capital.

MediumQ3. For example, real GDP rises from $80 billion to $84 billion, and population rises from 20 million to 20.2 million. Calculate the growth rate of real GDP per capita. Show worked answer

Old per capita = 80,000,000,000 ÷ 20,000,000 = $4,000.
New per capita = 84,000,000,000 ÷ 20,200,000 ≈ $4,158.42.
Growth = (4,158.42 − 4,000) ÷ 4,000 × 100 ≈ 3.96%.
Check with the shortcut: real GDP grew 5% and population 1%, so about 5% − 1% = 4%. The exact answer, 3.96%, is close.

MediumQ4. Countries A and B both start with real GDP per capita of $5,000. A grows at 1% a year and B at 4% a year. Use the rule of 70 to estimate each country’s income after 70 years. Show worked answer

A: doubling time ≈ 70 ÷ 1 = 70 years, so it doubles once: $5,000 → about $10,000.
B: doubling time ≈ 70 ÷ 4 = 17.5 years, so in 70 years it doubles 70 ÷ 17.5 = 4 times: $5,000 → $10,000 → $20,000 → $40,000 → about $80,000.
A 3-percentage-point gap in growth leaves B about eight times richer. (The rule of 70 is an approximation; exact compounding gives about $10,034 for A and $77,858 for B.)

MediumQ5. A factory produces 1,200 units a week with 40 workers. After a training programme, the same 40 workers produce 1,320 units. Calculate labour productivity before and after, and the percentage change. Show worked answer

Before: 1,200 ÷ 40 = 30 units per worker.
After: 1,320 ÷ 40 = 33 units per worker.
Change: (33 − 30) ÷ 30 × 100 = 10%.
Training has raised human capital, so each worker produces 10% more. Across the whole economy, this kind of change shifts LRAS to the right.

ExamQ6. A government increases spending on education and training. (a) Using a correctly labelled AD–AS diagram, show the long-run effect on real output and the price level, assuming AD is unchanged. (b) Explain why this policy may also shift AD in the short run. (c) Evaluate whether this is a better way to increase growth than cutting income tax. [8 marks] Show worked answer

(a) [3 marks] Correctly labelled axes: price level (vertical) and real GDP (horizontal) [1]. LRAS shifts right from LRAS$_1$ to LRAS$_2$ [1]. With AD unchanged, real GDP rises from $ Y_1 $ to $ Y_2 $ and the price level falls from $ P_1 $ to $ P_2 $ [1].
(b) [1 mark] Education spending is part of government spending (G), a component of AD, so AD shifts right in the short run.
(c) [4 marks] For education: raises human capital and productivity [1]; corrects under-consumption of a merit good with positive externalities and may reduce inequality [1]. Against: costly to the budget and has a long time lag before students join the workforce [1]. Income tax cuts may work faster and cost less in spending terms, but the incentive effect on hours worked may be small and gains go mostly to higher earners. Justified conclusion, e.g. education is likely the better long-run policy if skills are the main constraint, but tax cuts may be preferred if the aim is a quicker effect [1].

Check yourself

1. Which of these shifts the LRAS curve to the right?

Technology raises productive capacity; the other two shift AD, not LRAS.

2. Real GDP grows by 6% and population grows by 2%. Roughly how fast is real GDP per capita growing?

Per capita growth ≈ GDP growth − population growth = 6% − 2% = 4%.

3. Which is a market-based supply-side policy?

Deregulation frees up markets; the other two are interventionist spending.

Your score: 0 out of 3

The short version

Long-run growth is an increase in productive capacity: the PPC shifts out and LRAS shifts right.
Real GDP per capita measures living standards; the rule of 70 gives the doubling time: $ 70 \div $ growth rate (%).
Growth comes from physical capital, human capital, technology, natural resources and institutions, working through productivity.
Market-based supply-side policies (deregulation, tax cuts, privatisation, labour-market reform) sharpen incentives; interventionist ones (education, infrastructure, R&D) fix market failures but cost money and take time.
Growth is sustainable only if it does not damage the environment or use up resources that future generations will need.