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Causes of economic growth

Edexcel IAL Economics · WEC12 Macroeconomic performance and policy

Actual growth is a rise in real output; potential growth is a rise in the economy's capacity to produce. Long-term prosperity needs both.

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Actual and potential growth

Actual growth: an increase in real GDP. On a PPF it is a move from a point inside towards the frontier; on AD/AS it comes from AD shifting right.
Potential growth: an increase in the productive capacity of the economy, an outward shift of the PPF or a rightward shift of LRAS.

Actual growth can exceed potential growth for a while if there is spare capacity, but in the long run it is limited by potential growth.

Causes of actual growth

Increases in any component of AD: consumption (confidence, rising real incomes), investment, government spending and net exports.

Export-led growth: economies such as many in East Asia grew rapidly by selling to world markets. International trade lets a country specialise in its comparative advantage, gain economies of scale, and earn foreign currency to import capital goods and technology. It makes the economy dependent on world demand, though.

Causes of potential growth

Investment, both domestic and foreign direct investment (FDI): more and better capital; FDI also brings technology and management skills.
Innovation: new products and processes.
Growth of the labour force: higher participation, a growing working-age population and net inward migration.
Degree of competition: competitive markets push firms to innovate and cut costs.

Productivity

Labour productivity = output per worker (or per hour). Rising productivity is the main source of long-run growth in living standards, because it raises output without needing more inputs. It depends on capital per worker, skills, technology, management and infrastructure.

Worked example

A factory produces 12,000 units a week with 80 workers. After new machinery it produces 13,500 units with 75 workers. Find the change in labour productivity.

Before: 12,000 / 80 = 150 units per worker
After: 13,500 / 75 = 180 units per worker
% change = (180 - 150) / 150 x 100 = 20%

Answer: Productivity rose by 20%

Key idea: Actual growth: real GDP rises (AD). Potential growth: capacity rises (LRAS/PPF out) via investment, FDI, innovation, labour force, competition. Productivity = output per worker.

Check yourself

An economy produces $600 bn of output with 20 million workers. Find output per worker in $.
Show answer
$30000. 600,000,000,000 / 20,000,000 = $30,000.
Output per hour rises from 42 to 43.26 units. Find productivity growth in %.
Show answer
3 %. (43.26 - 42) / 42 x 100 = 3%.
Which is an example of potential economic growth?
- A movement from inside the PPF towards it
- A rise in AD with spare capacity
- A fall in unemployment during a recovery
- An outward shift of the production possibility frontier
Show answer
An outward shift of the production possibility frontier. Potential growth is an increase in capacity.
In a recession with high unemployment, a rise in government spending mainly causes
- actual growth
- potential growth only
- a fall in productive capacity
- an inward shift of the PPF
Show answer
actual growth. Spare capacity is used up as AD rises.
Why can foreign direct investment raise potential growth?
- It reduces exports
- It is a withdrawal from the circular flow
- It adds capital and often brings new technology and management skills
- It lowers the labour force
Show answer
It adds capital and often brings new technology and management skills. FDI raises the capital stock and spreads know-how.
A risk of relying on export-led growth is that
- the economy is vulnerable to falls in world demand
- it always causes deflation
- it reduces specialisation
- it prevents economies of scale
Show answer
the economy is vulnerable to falls in world demand. If trading partners enter recession, exports and growth fall.
Explain why productivity is important for long-run economic growth.
Show answer
Higher productivity means more output from each worker or hour, raising potential output and real incomes without needing more inputs, so living standards can rise sustainably.. Productivity raises capacity per worker, the basis of rising living standards.

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Sources

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification, Issue 2 (June 2018)

Last updated 8 November 2026. Spotted a mistake? Tell us.