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Lesson summary: Economic growth

AP.MACRO:
MEA‑2 (EU)
,
MEA‑2.B (LO)
,
MEA‑2.B.1 (EK)
,
MEA‑2.B.2 (EK)
,
MEA‑2.B.3 (EK)
,
MEA‑2.B.4 (EK)
,
MEA‑2.B.5 (EK)
,
MOD‑1 (EU)
,
MOD‑1.B (LO)
,
MOD‑1.B.1 (EK)
In this lesson summary review and remind yourself of the key terms and concepts related to economic growth, including expansion of capital, technological change, and human capital.

Lesson summary

An economy grows when it has the capacity to produce more. Production is based on how much capital, labor, natural resources, and technology it has to produce. Policies that encourage the accumulation of any of these leads to economic growth.
We’ve already seen the capacity to produce represented in two models: the production possibilities curve and the long-run aggregate supply curve. Economic growth is a shift out of either of these curves.

Key Terms

Key termDefinition
economic growtha sustained increase in real GDP per capita over time
output per capita(also called real GDP per capita) output divided by population; for example, if real GDP is dollar sign, 100 million and the population is 2 million, real GDP per capita is dollar sign, 50 per person.
productivity(also called labor productivity) the amount of output produced per unit of labor
human capitalimprovements in education, knowledge, and wealth that make each unit of labor more productive
supply-side policiesgovernment policies that promote rightward shifts of aggregate supply, such as increasing labor force participation and incentives to save and invest

Key Takeaways

An increase in real GDP is not necessarily economic growth

Economic growth means that an economy has increased its ability to produce more. When an economy is producing beyond potential output, it might have experienced an increase in real GDP, but that is not economic growth. Similarly, an economy that is recovering from a recession might experience an increase in real GDP, but that is not economic growth.

Sources of economic growth

Economic growth is an increase in the capacity to produce. Therefore anything that increases that capacity is economic growth.
The ability to produce depends on:
  • The stock of capital per worker: All else equal an economy with more physical capital can produce more than an economy with less physical capital. Because savings and investment add to the stock of capital, more investment in capital leads to more economic growth.
  • The amount and quality of labor: As long as the capital per worker does not decrease, more labor leads to more production. For example, 4 people that each have a waffle maker make fewer waffles than 10 people that each have a waffle maker. Also, improvements in human capital, such as education and health, improve the productivity of that labor.
  • The level of technology
    • the know how to combine labor, capital, and natural resources to produce is an important aspect of production. Improvements in technology increase productivity.

Government policies can impact economic growth

Government policies play a big part in encouraging (or discouraging) economic growth. Some examples of economic policies that contribute to economic growth are:
  • Investing in infrastructure: infrastructure, like highways or bridges, are physical capital that is available to everyone. By investing in infrastructure, governments add to the capital stock of a country. But infrastructure depreciates, just like any other capital. That means governments must replace depreciated infrastructure to maintain it.
  • Policies that affect productivity and labor force participation
    • Encouraging a higher labor force participation rate, such as tax incentives on labor for participation, can lead to more economic growth.
  • Policies that encourage capital accumulation and technological change
    • Policies that encourage savings, and therefore investment in capital, lead to higher economic growth. Similarly, policies that encourage technological change, such as tax credits for research and development, also lead to more economic growth.

Key Graphical Models

Economic growth in the production possibilities curve (PPC) model

The production possibilities curve illustrates the maximum combination of output of two goods that an economy can produce, such as capital goods and consumption goods. If that curve shifts out, the capacity to produce has increased.
Figure 1: Economic growth in the PPC model

Economic growth in the AD-AS model

Recall that the long-run aggregate supply curve (LRAS) is vertical at the full employment rate of output. That means that if the full employment output increases (in other words, moves to the right along the horizontal axis), then the LRAS curve shifts to the right:
Figure 2: Economic growth in the AD-AS model

Common misperceptions

  • Economic growth is the long-run trend of an increase in output over time, not just a temporary fluctuation in output or using previously underutilized resources.

Questions for review

  • Show the impact that an increase in the supply of loanable funds would have on the PPC of an economy. Explain.
  • Show the impact that a decrease in the capital stock would have on the LRAS of an economy. Explain.

Want to join the conversation?

  • blobby green style avatar for user johnpaul122jpr
    I have a question about the definition of "economic growth." In the table, it is defined as "a sustained increase in real GDP per capita over time," but, later on in the article, it is stated as being "an increase in the capacity to produce."

    These definitions, while similar to a degree, do not mean the same thing. An increase in production capacity does not inherently mean that GDP per capita is increasing. For example, if output and production capacity increase at the same rate as population, under the first definition there would be no economic growth, but in the second, there is.

    Some of the other definitions I have commonly seen for "economic growth" are:
    - an increase in:
    - Real GDP
    - Real GDP per capita
    - full employment Real GDP
    - full employment Real GDP per capita


    My question:
    What is the actual definition of economic growth? Is it dependent on context? Am I completely mistaken?

    Any help would be greatly appreciated.
    (6 votes)
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    • starky tree style avatar for user melanie
      Its both. You can't have a sustained increase in output unless you have an increase in the ability to do so. But simply an increase in capacity to produce isn't economic growth unless its put to use. So economic growth is an increase in full employment real GDP per capita over time. It's not (necessarily) just an increase in output.

      The other "definitions" are really just ways of (sloppily) referring to growth. As an economist professor friend of mine said, "Any old increase in GDP is not economic growth" . There is a tendency for people to refer to increases in real GDP as "economic growth". To be fair, thats because it usually is economic growth, because economies increase capacity over time. However, it is also possible that an economy is just pushing its production past what is sustainable. The best analogy for that scenario is cramming for an exam. Perhaps temporarily you can study 21 hours a day and get just a few hours sleep a night, but if you did that every day you'd eventually collapse. For an economy, maybe you can make all your workers work overtime, draw people who don't usually want to work into the labor force, etc. But eventually, if your true capacity to produce hasn't changed, you will go back to producing output.
      (9 votes)
  • blobby green style avatar for user SulakShana Sumaruth
    Distinguish between economic growth and economic development?
    (3 votes)
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  • blobby green style avatar for user Anuj Khadka
    how does capital forms?
    (3 votes)
    Default Khan Academy avatar avatar for user