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What causes economic growth — supply and demand side

EU2.3 — Macroeconomics › EU2.3.2 — Economic GrowthLecture 1 of 2~2690 words
Before this
This leads to

Two countries that started in the same place

In 1960, the average person in Ghana produced a little more than the average person in South Korea. Both countries were poor. Korea had come out of a destructive war only seven years earlier. Ghana had become independent in 1957, with good hopes.

Then their paths split. Here is real GDP per head, in constant US dollars, so that rising prices are already removed:

Country19602024Times as much
Ghana≈ 1100≈ 2170≈ 2
South Korea≈ 1040≈ 37 000≈ 36

Source: World Bank, World Development Indicators, GDP per capita at constant prices, through FRED (Federal Reserve Bank of St. Louis), series for Ghana and the Republic of Korea.

The typical Ghanaian today produces about twice as much as in 1960. The typical Korean produces about 36 times as much. Now look at Japan. Its real GDP per head grew about 4.5 times between 1960 and 1990. Then, between 1990 and 2024, it grew only about 31% in total, the same data shows.

So growth is not a law of nature that every country receives at the same rate. Some economies race. Some stall for decades. Some race and then slow down. This lecture asks what is actually going on underneath. The lectures on national income promised it: having measured an economy, we now ask what makes it grow.

What growth means, and why small rates matter

Economic growth is a rise in a country's real GDP over time. Real, because a rise caused only by higher prices is not more output. You met this in the lecture on real and nominal GDP. The growth rate is the percentage change from one year to the next:

growth rate = (real GDP this year − real GDP last year) ÷ real GDP last year × 100%

Growth rates look small: 2%, 3%, 6% a year. But growth compounds. Each year's growth is added to a bigger base than the year before. A useful approximation, the rule of 70, gives the number of years an economy takes to double:

doubling time in years ≈ 70 ÷ growth rate in % per year

At 1% a year, output doubles in about 70 years. At 7% a year, it doubles in about 10 years. Korea's real GDP per head grew at about 5.7% a year on average from 1960 to 2024. That is a doubling roughly every 12 years, five times over. Ghana's grew at about 1.1% a year. The whole difference in the table comes from a gap of under five percentage points, held for sixty years.

Two different kinds of growth

Here is the idea the rest of the lecture rests on. An economy's real GDP can rise in two very different ways.

Think of a factory with ten machines. In a bad year, only seven are running, because orders are low. If orders pick up, the owner switches on the other three. Output rises. But the factory is no bigger than before. It is only using what it already had.

Now suppose the owner buys two new machines and trains the workers to use them faster. Now the factory could produce more even when every machine is running. Its capacity has grown.

A whole economy works the same way. You met the picture in the lecture on the production possibility frontier (PPF).

O Capital goods Consumer goods PPF₁ PPF₂ A B C A → B: using spare capacity · B → C: more capacity
A is inside the frontier: workers are unemployed and machines stand idle. Moving from A to B uses that spare capacity. Moving from B to C needs more capacity: the frontier itself moves out, from PPF₁ to PPF₂.

Short-run growth has a limit. Once the economy reaches the frontier, there is no more spare capacity to use. Only long-run growth can continue for sixty years. That is it. That is the whole idea. Korea did not grow 36 times by switching on idle machines. It built a much bigger economy.

Stop and think

A country's real GDP grows by 5% in one year, straight after a deep recession. Its government says this proves the economy has become much more productive. What should you ask before you agree?

Show the answer

Ask whether the economy was inside its frontier. After a recession, many workers and machines are idle. Putting them back to work raises output quickly, without any rise in capacity. That is a move from A towards B, not an outward shift. Fast growth after a recession is mostly recovery. The test of long-run growth is whether output keeps rising once the spare capacity has been used up.

The same idea on an AD-AS diagram

Economists also draw these two kinds of growth on a diagram with three lines. It looks like a supply and demand diagram, but it describes the whole economy, not one market.

On the vertical axis is the price level, an index of prices in general. On the horizontal axis is real GDP. In the figures below, both start at 100.

Demand grows, capacity does not Price level Real GDP LRAS SRAS AD₁ AD₂ 100 110 100 105 Capacity and demand grow together Price level Real GDP LRAS₁ LRAS₂ SRAS₁ SRAS₂ AD₁ AD₂ 100 110 100
Top: AD shifts right from AD₁ to AD₂ while capacity stays at 100. Real GDP rises from 100 to 110, beyond capacity, and the price level rises from 100 to 105. Bottom: capacity grows from 100 to 110 (LRAS₁ to LRAS₂, with SRAS shifting too), and AD grows with it. Real GDP reaches 110 and the price level stays at 100. Invented index numbers.

Compare the two pictures. Both end with real GDP at 110. But in the top picture the economy is pushed past its capacity. Firms compete for the same workers and materials, so costs and prices rise. This cannot last. In the bottom picture, capacity has grown, so the same rise in spending meets more production instead of higher prices.

Try it yourself below. Move each curve separately, and then together.

Build — demand, capacity and the price level

The first slider shifts aggregate demand. The second moves capacity (LRAS), and SRAS moves with it. Watch real GDP, the price level, and the gap between output and capacity. First move only demand. Then move only capacity. Then find a pair that gives growth with no change in the price level.

Presets:

An invented economy that starts with real GDP and the price level both at 100. Each row changes demand, capacity, or both.

AD shiftCapacityReal GDPPrice levelOutput vs capacity
0100100100At capacity
+1510011010510 above: prices rising
0110≈ 103.3≈ 96.7≈ 6.7 below: spare capacity
+10110110100At capacity
−15100909510 below: a recession

Demand alone raises output and prices. Capacity alone lowers prices, but output rises only part of the way unless spending grows too. Growth with steady prices needs both.

What should you have seen? Shifting demand alone moves output and prices up together, and once output passes capacity the readout warns that it cannot last. Raising capacity alone pulls prices down, but output rises only part of the way, because nobody is spending enough to buy the extra production. Growth with steady prices needs capacity and demand to grow together. This is why economists call supply-side growth the route to growth without inflation: capacity growth gives demand room to grow.

Where short-run growth comes from: spending

Short-run growth comes from a rise in aggregate demand. Each part of can push it.

Extra spending raises output when there is spare capacity. Near capacity, it mostly raises prices.

Where long-run growth comes from: capacity

Long-run growth needs the economy to be able to produce more. One way to see the sources is to split output into two parts:

real GDP = number of workers × output per worker

More workers, from a growing population or more people joining the labour force, raise GDP. But they do not raise GDP per head, which is what makes people better off on average. For that, output per worker must rise. Economists name four main sources.

The four work together. A machine needs a trained worker, and nobody invests where institutions are weak.

Sort — using capacity or building it?

For each event, ask: does it raise spending on what the economy can already produce, does it raise what the economy can produce, or both? Put it in a box.

Eight events, sorted by the kind of growth they cause.

  • Uses existing capacity (AD): interest rates are cut and households borrow to spend · factories closed in a recession reopen · incomes abroad rise and foreigners buy more exports.
  • Builds capacity (LRAS): a new way of organising work lets each clerk handle twice as many forms · more children finish secondary school · courts start enforcing contracts quickly and fairly.
  • Both: firms buy faster machines · the government builds a new port. The spending raises AD now, and the new capital raises capacity later.

The "Both" box is the important one. Investment links the two kinds of growth. It is part of today's demand, and it becomes tomorrow's capacity. That link is at the centre of the real case below.

Real case: how South Korea grew

Real case — South Korea (1960s to today)

The policy. From the 1960s, Korea's governments pushed the economy towards exporting manufactured goods. They steered bank credit to chosen industries, first light manufacturing and later heavy industry such as steel, ships and chemicals. They expanded schooling at every level. Korean firms began by making goods to other companies' designs, then learned to design and improve their own.

The prediction. The four sources predict fast growth in output per worker if capital, skills and technology all rise together. Exports add something more: foreign buyers provide demand far larger than a poor home market could, so the new capacity is actually used.

What happened. Investment rose enormously. Real gross capital formation, the spending on new capital goods, was about 74 times as large in 1990 as in 1960 (Bank of Korea data through FRED). Real GDP per head grew about 9 times over the same thirty years. Education rose with it. By 2022, 69.6% of Koreans aged 25 to 34 had completed tertiary education, the highest share in the OECD (OECD, Education at a Glance 2023). Real GDP per head is now about 36 times its 1960 level.

The verdict. Both kinds of growth worked together. Export demand pulled the economy forward, and investment in capital and people pushed capacity out to meet it. But economists still argue about the mix. In a 1994 essay, "The Myth of Asia's Miracle", Paul Krugman argued that East Asia's growth came mostly from more inputs, more capital and more workers, and much less from better technology. If that is right, growth from inputs alone would slow as capital per worker became large. Others reply that the shift of workers from farms into factories, and the learning of new technology, mattered more than his figures showed. Korea's growth has indeed slowed as it has become rich, though it remains positive.

Worked Example — Recovery is not the same as long-run growth (United Kingdom, 2008 onwards)

What happened. In the financial crisis, UK real GDP shrank by more than 6% between the first quarter of 2008 and the second quarter of 2009. It then took about five years to return to its size before the recession (Office for National Statistics, 2018).

Which kind of growth was the recovery? Mostly short-run. Spare workers and machines were brought back into use, a move back towards the frontier.

What about capacity? Here the news was worse. For about five decades before 2008, UK output per hour worked rose by around 2% a year. In the decade after 2008, it rose by only about 0.3% a year (ONS, 2020). The ONS calls this the "productivity puzzle". At 2% a year, output per hour grows about 22% in ten years. At 0.3% a year, it grows about 3%.

The lesson. GDP can recover, and still the frontier can move out much more slowly than before. Slow growth in output per hour is one reason why UK wages, after inflation, grew slowly in the 2010s.

Stop and think

Japan's real GDP per head grew by about 0.8% a year from 1990 to 2024. Its population has been falling since the late 2000s, and many workers have retired. Does "barely grown since 1990" describe Japan fairly?

Show the answer

Not fully. Total output has grown slowly, partly because the number of workers has stopped rising and begun to fall. Output per head still grew by about 31% over the period. So Japan's growth slowed sharply after 1990, but it did not stop. When you compare countries, always ask: growth of what? Total GDP, GDP per head, and output per worker can tell different stories.

Three traps

Trap 1 — Calling every rise in GDP "long-run growth"

A rise in real GDP after a recession is usually the economy using spare capacity again. Long-run growth means capacity itself has risen. On a diagram, short-run growth is a move to the frontier or a shift of AD. Long-run growth is a shift of the frontier or of LRAS.

Trap 2 — Thinking investment means buying shares

In economics, investment is spending on new capital goods: machines, buildings, roads, software. Buying shares only changes who owns existing firms. It adds to capacity only if the firm uses the money to buy new capital.

Trap 3 — Forgetting the population

Real GDP can grow because there are more people. If real GDP grows 3% and the population grows 3%, output per head has not grown at all. To judge living standards, look at real GDP per head.

Try it yourself

Work each one on paper first. Open a hint only when you are stuck.

  1. An invented country's real GDP rises from $800 billion to $836 billion in one year. Find the growth rate. At that rate, roughly how long would real GDP take to double?

    Hint 1

    Growth rate = change ÷ starting value × 100%.

    Hint 2

    The change is $36 billion. For the doubling time, use the rule of 70.

    Full answer

    Growth rate = 36 ÷ 800 × 100% = 4.5%. Doubling time ≈ 70 ÷ 4.5 ≈ 15.6 years, so about 16 years. Check: 1.045 multiplied by itself 16 times is about 2.02, so the estimate is close.

  2. A large storm destroys many of a country's roads and bridges. Show the effect on a PPF and on an AD-AS diagram. Is this a short-run or a long-run problem?

    Hint 1

    Has the amount the economy can produce changed?

    Hint 2

    Lost roads and bridges are lost physical capital.

    Full answer

    Physical capital is destroyed, so capacity falls. The PPF shifts inwards, and LRAS shifts left (SRAS with it). With the same demand, real GDP falls and the price level rises. It is a long-run problem until the capital is rebuilt. The rebuilding is interesting: it raises AD (spending on construction) and, once finished, restores capacity, an example of the "Both" box.

  3. Country A grows at 2% a year and country B at 3.5% a year. Both start with the same real GDP per head. Roughly how many times as large is each after 40 years?

    Hint 1

    Use the rule of 70 to find each doubling time.

    Hint 2

    A doubles every 35 years and B every 20 years. How many doublings fit in 40 years?

    Full answer

    A: 40 ÷ 35 ≈ 1.1 doublings, so a little over 2 times as large. B: 40 ÷ 20 = 2 doublings, so about 4 times as large. Exact check: 1.02⁴⁰ ≈ 2.21 and 1.035⁴⁰ ≈ 3.96. A gap of 1.5 percentage points makes B nearly twice as rich as A after one working life.

  4. In an invented country, the number of workers grows by 1% a year and output per worker by 1.5% a year. The population grows by 2% a year. Roughly how fast does real GDP grow? And GDP per head? What would you advise the government to focus on, and why?

    Hint 1

    Real GDP = workers × output per worker. Growth factors multiply.

    Hint 2

    Real GDP grows by a factor of 1.01 × 1.015. GDP per head grows by that factor divided by 1.02.

    Full answer

    Real GDP: 1.01 × 1.015 ≈ 1.0252, so about 2.5% a year. GDP per head: 1.0252 ÷ 1.02 ≈ 1.005, so only about 0.5% a year. At that rate, living standards take about 140 years to double (70 ÷ 0.5). The population is growing faster than the workforce, so each worker supports more people. Advice: raise output per worker (capital, skills, technology, institutions), and if possible help more adults into work. Adding workers alone cannot raise GDP per head when population grows just as fast.

The bigger idea

In 1988, the economist Robert Lucas compared the growth of different countries and wrote: "The consequences for human welfare involved in questions like these are simply staggering: Once one starts to think about them, it is hard to think about anything else." His article appeared in the Journal of Monetary Economics, volume 22. A few percentage points a year, held for decades, decide whether a child is born into a poor country or a rich one.

We know the ingredients well: capital, skills, technology, and institutions that let people trust the future. We are much less sure of the recipe, the mix of policies that produces them in a particular country at a particular time. That is why the next lectures ask a second question. Growth brings large benefits. It also brings costs, and who gains and who loses matters as much as how fast the total rises.

Key concepts in this lesson