Module 40 economic growth in macroeconomic models

ECONOMIC GROWTH IN ECONOMIC GROWTH IN MACROECONOMIC MACROECONOMIC

MODELSMODELS

MODULE 40MODULE 40

LONG-RUN ECONOMIC GROWTHLONG-RUN ECONOMIC GROWTH

Long-run economic growth is the Long-run economic growth is the sustained rise in the quantity of sustained rise in the quantity of goods and services the economy goods and services the economy produces as opposed to the short produces as opposed to the short run-ups and downs of the business run-ups and downs of the business cycle.cycle.

The fluctuations of actual output The fluctuations of actual output compared to potential output are the compared to potential output are the result of the business cycle.result of the business cycle.

LONG-RUN ECONOMIC GROWTHLONG-RUN ECONOMIC GROWTH

Long-run economic growth depends Long-run economic growth depends almost entirely on rising productivity.almost entirely on rising productivity.

Good macroeconomic policy strives Good macroeconomic policy strives to foster increases in productivity, to foster increases in productivity, which in turn lead to long-run which in turn lead to long-run economic growth.economic growth.

LONG-RUN ECONOMIC GROWTH AND THE LONG-RUN ECONOMIC GROWTH AND THE PRODUCTION POSSIBILITIES CURVEPRODUCTION POSSIBILITIES CURVE

The PPC is a graph that illustrates The PPC is a graph that illustrates the trade-offs facing an economy the trade-offs facing an economy that produces only two goods.that produces only two goods.

Economic growth is shown as an Economic growth is shown as an outward shift of the PPC.outward shift of the PPC.

In macroeconomics the PPC shows In macroeconomics the PPC shows two different categories of goods: two different categories of goods: investment goods and consumer investment goods and consumer goods.goods.


The consumer goods include The consumer goods include everything purchased for everything purchased for consumption by households.consumption by households.

Investment goods include all forms of Investment goods include all forms of physical capital, which are goods physical capital, which are goods used to produce other goods.used to produce other goods.

The bowed out shape of the PPC The bowed out shape of the PPC reflects increasing opportunity costs.reflects increasing opportunity costs.


The PPC shows all possible The PPC shows all possible combinations of consumer and combinations of consumer and investment goods that can be investment goods that can be produced with full and efficient use produced with full and efficient use of all the country’s resources.of all the country’s resources.

However, the PPC doesn’t tell us However, the PPC doesn’t tell us which of the possible points the which of the possible points the country should select.country should select.


Choosing to produce at a point on Choosing to produce at a point on the PPC that creates more capital the PPC that creates more capital goods for the economy will result in goods for the economy will result in greater production possibilities in the greater production possibilities in the future (and thus greater economic future (and thus greater economic growth).growth).


Over time, as an economy produces Over time, as an economy produces more goods and services, some of its more goods and services, some of its capital is used up in that production.capital is used up in that production.

A loss in the value of physical capital A loss in the value of physical capital due to wear, age, or obsolescence is due to wear, age, or obsolescence is called called depreciationdepreciation. .

Producing more consumer goods for Producing more consumer goods for the economy will result in a decrease the economy will result in a decrease in economic growth in the future.in economic growth in the future.


If an economy were to produce more If an economy were to produce more consumer goods than capital goods consumer goods than capital goods year after year, it would find its stock year after year, it would find its stock of capital goods depreciating and its of capital goods depreciating and its PPC curve would shift inward over PPC curve would shift inward over time, indicating a decrease in time, indicating a decrease in production possibilities. production possibilities.


The point where an economy The point where an economy chooses to produce depends on the chooses to produce depends on the values, politics, and other details values, politics, and other details related to the economy and people of related to the economy and people of the country.the country.

However, the choice made by the However, the choice made by the economy each year will affect the economy each year will affect the position of the PPC in the future.position of the PPC in the future.


An emphasis on producing consumer An emphasis on producing consumer goods will make consumers better off goods will make consumers better off in the short run, but will prevent the in the short run, but will prevent the PPC from moving farther out in the PPC from moving farther out in the future.future.

An emphasis on investment goods An emphasis on investment goods will lead the PPC to shift out farther will lead the PPC to shift out farther in the future, but will decrease the in the future, but will decrease the quantity of consumer goods available quantity of consumer goods available in the short run.in the short run.


A country’s decision regarding A country’s decision regarding investment in physical capital, investment in physical capital, human capital, and technology human capital, and technology affects its long-run economic growth.affects its long-run economic growth.

Governments can promote long-run Governments can promote long-run economic growth by investing in economic growth by investing in physical capital such as physical capital such as infrastructure, by promoting a well-infrastructure, by promoting a well-functioning financial system, functioning financial system, property rights, and political stability. property rights, and political stability.

LONG-RUN ECONOMIC GROWTH LONG-RUN ECONOMIC GROWTH AND THE AD-AS MODELAND THE AD-AS MODEL

The long-run AS curve shows the The long-run AS curve shows the quantity of aggregate output quantity of aggregate output supplied when all prices, including supplied when all prices, including nominal wages, are flexible.nominal wages, are flexible.

It is vertical at potential output It is vertical at potential output because in the long run a change in because in the long run a change in the aggregate price level has no the aggregate price level has no effect on the quantity of aggregate effect on the quantity of aggregate output supplied.output supplied.


While actual GDP is almost always While actual GDP is almost always above or below potential output, above or below potential output, reflecting the current phase of the reflecting the current phase of the business cycle, potential output is business cycle, potential output is the level of output around which the level of output around which actual aggregate output fluctuates. actual aggregate output fluctuates.

A rise in potential output corresponds A rise in potential output corresponds to a rightward shift of the LRAS to a rightward shift of the LRAS curve.curve.


The same government policies that The same government policies that promote an outward shift of the PPC promote an outward shift of the PPC promote a rightward shift of the promote a rightward shift of the LRAS curve.LRAS curve.

DISTINGUISHING BETWEEN LONG-RUN DISTINGUISHING BETWEEN LONG-RUN GROWTH AND SHORT-RUN FLUCTUATIONSGROWTH AND SHORT-RUN FLUCTUATIONS

Both the PPC model and the AD-AS Both the PPC model and the AD-AS model can help us distinguish model can help us distinguish between long-run growth and short-between long-run growth and short-run fluctuations due to the business run fluctuations due to the business cycle.cycle.


The points along the PPC are The points along the PPC are achievable if there is efficient use of achievable if there is efficient use of the economy’s resources.the economy’s resources.

If the economy experiences a If the economy experiences a macroeconomic fluctuation due to macroeconomic fluctuation due to the business cycle, production falls to the business cycle, production falls to a point inside the PPC.a point inside the PPC.

On the other hand, long-run growth On the other hand, long-run growth will appear as an outward shift of the will appear as an outward shift of the PPC curve.PPC curve.



In the AD-AS model, fluctuations of In the AD-AS model, fluctuations of actual aggregate output around actual aggregate output around potential output are indicated by potential output are indicated by shifts of AD or SRAS that result in shifts of AD or SRAS that result in short-run macroeconomic equilibrium short-run macroeconomic equilibrium above or below potential output.above or below potential output.

In this case, adjustments in nominal In this case, adjustments in nominal wages will eventually bring the wages will eventually bring the equilibrium level of real GDP back to equilibrium level of real GDP back to the potential level.the potential level.


Long-run economic growth is Long-run economic growth is represented in the AD-AS model as a represented in the AD-AS model as a rightward shift of the LRAS curve.rightward shift of the LRAS curve.

This corresponds to an increase in This corresponds to an increase in the economy’s level of potential the economy’s level of potential output.output.


Technology

Module 40 economic growth in macroeconomic models