Causes, costs and constraints on economic growth

Actual and Potential Growth

There are two different types of economic growth, known as actual growth and potential growth.

Actual growth is measured as increases in real GDP, and potential growth is an increase in the capacity in the economy.

Actual out means the real output which the country produces with the current employment of factors of production. And we have to note here that not all the available resources are employed at any given time.

However, potential output means what the economy could produce if all the resources are fully employed. Therefore, if there is an increase in resources, or if there is increase in productive capacity of the economy, then we say that the there is potential economic growth.

It is also important to compare the actual and potential growth, which is also known as the output gap. The output gap signifies the economy is operating with spare capacity, which also means unemployment. Therefore, if the output gap is too big, the unemployment will be a concern for the economy. However, if the aggregate demand exceeds aggregate supply, which also means the economy is trying to operate at overcapacity, there will be the problem of inflation.

Causes of economic growth.

Increase in aggregate demand

Growth can be achieved by increases in the components of aggregate demand, for example an increase in consumer spending. The size of this increase depends on the size of the multiplier, and therefore any changes in injections and leakages will have an impact on the degree of change in growth.

the following diagram shows increase in aggregate demand which results in increased output.
AD-AS Curve 1

As we can see that the outward shift of AD increased real national output. A positive change to any component of aggregate demand ((C+I+G+X-M)) will increase aggregate demand and can result in economic growth in the short run. However, price also could increase as we can see from the diagram. The more inelastic the AS curve is, the higher the increase in price will be due to any increase in aggregate demand. That means If there is spare capacity in the economy then an increase in AD will cause a higher level of real GDP.

AD can increase for the following reasons:

Lower interest rates – Lower interest rates reduce the cost of borrowing and so encourages spending and investment.

Increased wages. Higher real wages increase disposable income and encourages consumer spending.

Increased government spending (G).

Fall in value of the country’s currency which makes exports cheaper and increases quantity of exports(X).

Increased consumer confidence, which encourages spending (C).

Lower income tax which increases disposable income of consumers and increases consumer spending (C).

Increase in aggregate supply

AS and AD Curve
Economic growth can also be achieved by an increases or improvements in any of the factors of
production, eg productivity growth or immigration. The effect is to shift the aggregate supply curve to the right.The diagram on the left shows shor-run AS curve.
Economic growth can also be shown by a long run rightward shift of the AD and AS Curves shown in the diagram below.


AD-AS Curve

LRAS or potential growth can increase for the following reasons:

– Increased capital. e.g. investment in new factories or investment in infrastructure, such as roads and telephones.
– Increase in working population, e.g. through immigration, higher birth rate.
– Increase in Labour productivity, through better education and training or improved technology.
– Discovering new raw materials.
– Technological improvements to improve the productivity of capital and labour e.g. Microcomputers and the internet have both contributed to increased economic growth.

Similarly, if there is any opposite change to the above causes, it will turn out to be a constraint on economic growth.


Real economic growth stimulates higher employment since labour is a derived demand. An increase in real GDP should cause an outward shift in the aggregate demand for labour. Not all industries will share in the growth of an economy.

The accelerator effect of growth on capital investment: Rising demand and output encourages investment in capital – this helps to sustain GDP growth by increasing LRAS.

Higher revenue for the government
Growth has a positive effect on Government finances – boosting tax revenues and helping to reduce the budget deficit. More people in work, rising spending and higher company profits all contribute to an increased flow of revenue to the Treasury.

Greater business confidence: Growth has a positive impact on profits & business confidence.

Improvements in living standards: Growth is an important avenue through which per capita incomes can rise and absolute poverty can be reduced in developing nations.


Inflation risk
If the economy grows too quickly there is the danger of inflation as demand races ahead of the ability of the economy to supply goods and services. Producer then take advantage of this by raising prices for consumers.

Fast growth can create negative externalities (increased pollution and congestion) which damages overall social welfare

Not all of the benefits of economic growth are evenly distributed. We can see a rise in national output but also growing income and wealth inequality in society. There will also be regional differences in the distribution of rising income and spending.

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