Lesson 14: Economic Growth

Hook

In 1960, South Korea's income per person was comparable to many of the world's poorest economies. Two generations later it sits among the richest nations on Earth. Nothing in Units 3–4 explains that — no AD shift, no interest-rate cut, no stimulus package turns subsistence farming into semiconductor factories. That transformation is economic growth: the slow, compounding expansion of what an economy can produce. It's the only force in this course that permanently raises living standards, and on the AP exam it's the answer to every question that contains the phrase "in the long run, potential output…" This lesson is about what feeds the machine — and what starves it.

Core Concepts

What growth is (and what it isn't)

Economic growth = a sustained increase in potential output — shown as the LRAS curve (and the PPC) shifting right — and, for living standards, measured as rising real GDP per capita.

Growth is not recovery. Moving from inside the PPC back to the curve (closing a recessionary gap) uses existing capacity; growth builds new capacity. The business cycle wiggles around the trend; growth is the trend (Lesson 2's upward-sloping potential-output line).

Because growth compounds, small rate differences become enormous over decades. (Handy aside: the rule of 70 — years to double ≈ 70 ÷ annual growth rate. An economy growing at 2% doubles in ~35 years; at 3.5%, in ~20.)

Productivity: the engine

Productivity = output per worker (per hour). Living standards track productivity almost one-for-one over the long haul. The aggregate production function says output per worker rises with:

1. Physical capital per worker — machines, tools, infrastructure. More capital per worker → more output per worker, but with diminishing returns: each added machine helps less than the last. (This is why capital-poor countries can grow fast by accumulating, and why rich countries can't grow on capital alone.)
2. Human capital per worker — education, training, skills, health. A literate, skilled workforce wrings more from any machine.
3. Technology — better recipes for combining inputs. Technology is the escape hatch from diminishing returns: it raises output at every level of capital, and it's the dominant source of sustained growth in advanced economies.
4. (Natural resources help but are neither necessary nor sufficient — think resource-poor Japan vs. resource-rich stagnant economies.)

Where capital comes from: the investment bridge

New physical capital requires investment, and investment is financed by saving — the loanable funds market (Lesson 11) is growth's bank teller:

• Higher national saving → supply of loanable funds right → real interest rate falls → more investment → faster capital accumulation → LRAS marches right faster.
• Persistent government deficits → crowding out → less investment → slower growth. (Unless the government is borrowing to build productive infrastructure or human capital — composition matters.)
• The Lesson 1 tradeoff completes the circle: producing capital goods today means fewer consumer goods today but a bigger PPC tomorrow.

Growth policies (the FRQ menu)

All of these shift LRAS right (with SRAS following, and the PPC outward). Contrast with demand policy: stimulus moves the economy along or toward its potential; growth policy moves the potential itself.

Apply It: Classify each as promoting growth (LRAS right) or managing demand (AD): (1) an investment tax credit; (2) a one-time stimulus check; (3) national broadband buildout; (4) a central-bank rate cut. → (1) growth (more capital); (2) demand; (3) growth (infrastructure/technology); (4) demand.

Graph Focus

[GRAPH: Economic growth in the AD-AS model
X-axis: Real GDP (Y)
Y-axis: Price level (PL)
Curves: LRAS₁ vertical at Yf₁; SRAS₁; AD₁ — initial long-run equilibrium
Shift: capital accumulation + technology → LRAS₁ shifts right to LRAS₂
(vertical at Yf₂ > Yf₁), SRAS₁ shifts right with it to SRAS₂
New long-run equilibrium: higher potential output; price level lower or stable
(depending on AD) — growth is the anti-inflationary way to raise output]

[GRAPH: Same story on the PPC
X-axis: Consumer goods
Y-axis: Capital goods
Curve: PPC₁ shifting outward to PPC₂
Annotation: an economy choosing a capital-rich point on PPC₁ experiences a
LARGER outward shift than one choosing a consumption-rich point]

AP labeling requirements: growth = LRAS shifts right (label Yf₁ → Yf₂); SRAS typically shifts right alongside; on the PPC version, the whole curve moves out. If an FRQ asks "show the effect on potential output," the vertical line must visibly move — shifting only AD or only SRAS scores zero on that part.

Common Traps

• Recovery ≠ growth. Rehiring idle workers moves the economy back to the curve/LRAS; growth moves the curve itself. Watch for "returns to full employment" (recovery) vs. "potential output rises" (growth).
• Demand policy doesn't cause growth. AD shifts change output temporarily (Lessons 7, 13). Only supply-side fundamentals move Yf. "Stimulus raises potential output" is a trap distractor.
• Diminishing returns to capital — but not to technology. Piling up identical machines eventually adds little; better ideas keep paying. That asymmetry is why technology is the long-run star.
• Population growth vs. per-capita growth. More workers raise total GDP, but living standards need output per person to rise — productivity, not headcount.
• Deficits and growth. The crowding-out channel (deficit → r↑ → I↓ → slower capital accumulation) is the standard exam link between fiscal policy and long-run growth. Know it in both directions (surpluses crowd in).

Practice Problems

FRQ Practice (Long)

The economy of Meridale is at full employment. Its government wants to raise the economy's long-run growth rate and is considering a permanent investment tax credit for businesses. Meridale's budget is currently balanced, and the credit would be financed by government borrowing.

(a) Draw a correctly labeled loanable funds market graph showing the effect of the investment tax credit on the demand for loanable funds. Label the initial and new real interest rates r₁ and r₂.

(b) The borrowing to finance the credit ALSO affects the loanable funds market. Does this borrowing reinforce or offset the interest-rate effect from part (a)? Explain.

(c) Assume the tax credit succeeds in raising the economy's rate of capital accumulation. Show the long-run effect on a correctly labeled AD–SRAS–LRAS graph, identifying the change in potential output.

(d) Explain how the increase in the capital stock affects productivity, and why this matters for living standards.

(e) Identify one alternative policy (not involving physical capital) that could also raise Meridale's long-run growth, and state its mechanism.

Model response & scoring (8 points)

• (a) 2 pts: Loanable funds graph with real interest rate on the y-axis, upward S_LF and downward D_LF (1); the credit raises the expected return on capital → D_LF shifts right → r₂ > r₁ (1).
• (b) 1 pt: Reinforces — deficit financing adds government borrowing to the demand for loanable funds, shifting D_LF even farther right and pushing the real rate higher still (partially crowding out some private projects).
• (c) 2 pts: AD-AS graph with LRAS shifting right (Yf₁ → Yf₂), SRAS shifting right alongside (1); potential output rises — the new long-run equilibrium is at higher real GDP (1).
• (d) 2 pts: More capital per worker raises output per worker — productivity (1); real GDP per capita, and thus material living standards, track productivity in the long run (1).
• (e) 1 pt: Any one with mechanism: education/training funding (human capital ↑ → productivity ↑); R&D subsidies or patent protection (technology ↑); institutional/property-rights reform (raises returns to investment and innovation).