Economic growth Economic growth can be defined as an increase in actual or potential GDP Using AD/AS analysis, draw an increase in actual GDP (hint, think of this in terms of the latest quarterly number, ie in the short-run) Give an example of why actual GDP might increase and how the government might help this happen

Increase in actual GDP – increase in AD Price Level Actual GDP (real GDP) increases if aggregate demand increases AD = C + I + G + (X – M) So AD might increase if: Consumption increases. Could happen if the government cuts income taxes, or if the Bank of England lowers interest rates Investment increases. Could happen if the government reduced corporation taxes, or again if the Bank of England cut interest rates If G increases. If the government built a new hospital in Surbiton…. If exports increase SRAS P2 P1 AD2 AD1 Y1 Y2 Real Output

Increase in actual GDP – increase in SRAS Price Level Can also happen if SRAS shifts as a result of a reduction in costs For example, if the government cuts taxes on firms, firms can lower prices, so SRAS shifts down Since the AD curve is downward sloping, this means an extension along the AD curve and so a higher level of real output = growth An improvement in productivity will also lead to the same impact, so government policies to improve productivity will also lead to an increase in actual GDP SRAS1 SRAS2 P1 P2 AD Y1 Y2 Real Output Which curve should you shift? In general you should shift AD since government policy on growth in the short-run is focussed on aggregate demand. You would only shift SRAS if a question was focussed on the impact of a change in costs

Increase in potential GDP Using AD/AS analysis show on a diagram an increase in potential GDP How might the government help to increase potential GDP

Increase in potential GDP (classical model) Price Level LRAS1 LRAS2 An increase in potential GDP can be shown with the LRAS curve (or with the PPF) We will look in more detail at this when we consider supply side policies, but LRAS shifts out when There is more or better capital. So the government can encourage investment When there is more or better labour. So the government can try to increase the size of the workforce, and to make it more efficient P1 P2 AD Y1 Y2 Real Output

Importance of international trade On the specification: What is export-led growth? When an increase in exports is the reason for actual growth (ie aggregate demand increasing) This growth leads to an increase in investment to fulfil demand, and so LRAS shifts out – potential growth Which countries have grown this way? Why is export-led growth a good thing? Growth in demand generally means an increase in imports (as incomes rise, demand for imports rises) and so a current account deficit Export-led growth means exports rise first, so a country will have a current account surplus Can all countries grow this way?

Importance of international trade Let’s say each country can produce 12 units of what it is good at if it uses all its resources to produce that good, or 3 of the others. Let’s then say UK, China and Germany do not trade, but devote one third of total resources to each product for their own consumption. Output will be as below in red, with each country producing one third of potential output for each good. Imagine then the UK only produces banking services, China clothes and Germany cars. Output is shown in green. Total world output rises to 12 for each product, and with trade, all countries are better off. This is because the UK would just produce banking services and export them in return for cars from Germany and clothes from China (perhaps 1 for 1) More advanced: international trade enables all countries to grow This is because countries can produce more of what they are relatively, or comparatively good at producing, then export these goods to pay for imports of products they are not so good or efficient at producing China can specialise in low to mid end manufactures like clothes (and steel?), Germany in cars, and the UK in services like banking So China produces clothes for the UK and Germany. We export banking services to pay for these clothes, whilst Germany exports cars All countries can be better off, which means economies grow faster because of international trade Clothes Cars Banking UK 1 4 12 Germany China Total 6