Economists talk about short run and long run growth. Short run growth is just an increase in output (like above). Long run growth is an increase in capacity. Think about it like a school. In the short run a school can grow numbers by increasing the number of desks in the classroom but this creates problems and can’t keep going forever. Eventually they must increase the capacity of the school by building new classrooms, then they can take more students than it was possible to take before.

 

Short Run Growth

Increasing aggregate demand leads to an increase in output. This increase in AD could be caused by anything that impacts one of the components of AD (consumption spending, investment spending, government spending or an improvement in the balance of trade).

e.g:

  •  An increase in incomes
  • A fall in interest rates
  • Looser fiscal policy
  • A fall in the exchange rate

In the short run it is possible to grow by increasing demand and using more of the capacity the economy already has but unless there is lots of spare capacity in an economy – high unemployment and lots of firms underusing their machinery then there will be inflation. The closer an economy gets to full capacity the more inflation there will be when AD rises and the less increase in output

Short Run AS/AD Diagram showing economic growth

 

Long Run Growth

Long run growth is caused by increasing the productive capacity of an economy. This is show by shifting the PPF or long run aggregate supply curve right. It is more desirable than short run growth as it is possible to continually grow this way without inflation.

Long run growth can be achieved by improving or increasing on of the factors of production. For example:

  • Finding new resources such as oil
  • Training the workforce better or increasing its size through immigration
  • Investing in more capital/infrastructure or researching and developing new types.

It is more sustainable than short run growth and does not cause inflation but most supply-side policies are very slow to take effect and the spending required may create even more inflation in the short run.

Classical Long Run AS/AD Diagram showing economic growth

Published in The National Economy