Long-run economic growth is defined as a sustained rise in output over time, as opposed to short-term business cycle fluctuations. Growth depends on rising productivity, which is fostered by good policy promoting capital investment, education, technology, and stability. This is shown as an outward shift of the production possibilities curve (PPC) and a rightward shift of the long-run aggregate supply (LRAS) curve. While actual output varies in the short run, potential output increases through long-run growth.

1. ECONOMIC GROWTH IN
MACROECONOMIC
MODELS
MODULE 40

2. LONG-RUN ECONOMIC GROWTH
 Long-run economic growth is the
sustained rise in the quantity of
goods and services the economy
produces as opposed to the short
run-ups and downs of the business
cycle.
 The fluctuations of actual output
compared to potential output are the
result of the business cycle.

3. LONG-RUN ECONOMIC GROWTH
 Long-run economic growth depends
almost entirely on rising productivity.
 Good macroeconomic policy strives
to foster increases in productivity,
which in turn lead to long-run
economic growth.

4. LONG-RUN ECONOMIC GROWTH AND THE
PRODUCTION POSSIBILITIES CURVE
 The PPC is a graph that illustrates
the trade-offs facing an economy
that produces only two goods.
 Economic growth is shown as an
outward shift of the PPC.
 In macroeconomics the PPC shows
two different categories of goods:
investment goods and consumer
goods.

5. LONG-RUN ECONOMIC GROWTH AND THE
PRODUCTION POSSIBILITIES CURVE
 The consumer goods include
everything purchased for
consumption by households.
 Investment goods include all forms
of physical capital, which are goods
used to produce other goods.
 The bowed out shape of the PPC
reflects increasing opportunity costs.

6. LONG-RUN ECONOMIC GROWTH AND THE
PRODUCTION POSSIBILITIES CURVE
 The PPC shows all possible
combinations of consumer and
investment goods that can be
produced with full and efficient use
of all the country’s resources.
 However, the PPC doesn’t tell us
which of the possible points the
country should select.

7. LONG-RUN ECONOMIC GROWTH AND THE
PRODUCTION POSSIBILITIES CURVE
 Choosing to produce at a point on
the PPC that creates more capital
goods for the economy will result in
greater production possibilities in the
future (and thus greater economic
growth).

8. LONG-RUN ECONOMIC GROWTH AND THE
PRODUCTION POSSIBILITIES CURVE
 Over time, as an economy produces
more goods and services, some of its
capital is used up in that production.
 A loss in the value of physical capital
due to wear, age, or obsolescence is
called depreciation.
 Producing more consumer goods for
the economy will result in a decrease
in economic growth in the future.

9. LONG-RUN ECONOMIC GROWTH AND THE
PRODUCTION POSSIBILITIES CURVE
 If an economy were to produce more
consumer goods than capital goods
year after year, it would find its
stock of capital goods depreciating
and its PPC curve would shift inward
over time, indicating a decrease in
production possibilities.

10. LONG-RUN ECONOMIC GROWTH AND THE
PRODUCTION POSSIBILITIES CURVE
 The point where an economy
chooses to produce depends on the
values, politics, and other details
related to the economy and people of
the country.
 However, the choice made by the
economy each year will affect the
position of the PPC in the future.

11. LONG-RUN ECONOMIC GROWTH AND THE
PRODUCTION POSSIBILITIES CURVE
 An emphasis on producing consumer
goods will make consumers better off
in the short run, but will prevent the
PPC from moving farther out in the
future.
 An emphasis on investment goods
will lead the PPC to shift out farther
in the future, but will decrease the
quantity of consumer goods available
in the short run.

12. LONG-RUN ECONOMIC GROWTH AND THE
PRODUCTION POSSIBILITIES CURVE
 A country’s decision regarding
investment in physical capital,
human capital, and technology
affects its long-run economic growth.
 Governments can promote long-run
economic growth by investing in
physical capital such as
infrastructure, by promoting a well-
functioning financial system,
property rights, and political stability.

13. LONG-RUN ECONOMIC GROWTH
AND THE AD-AS MODEL
 The long-run AS curve shows the
quantity of aggregate output
supplied when all prices, including
nominal wages, are flexible.
 It is vertical at potential output
because in the long run a change in
the aggregate price level has no
effect on the quantity of aggregate
output supplied.

14. LONG-RUN ECONOMIC GROWTH
AND THE AD-AS MODEL
 While actual GDP is almost always
above or below potential output,
reflecting the current phase of the
business cycle, potential output is
the level of output around which
actual aggregate output fluctuates.
 A rise in potential output
corresponds to a rightward shift of
the LRAS curve.

15. LONG-RUN ECONOMIC GROWTH
AND THE AD-AS MODEL
 The same government policies that
promote an outward shift of the PPC
promote a rightward shift of the
LRAS curve.

16. DISTINGUISHING BETWEEN LONG-RUN
GROWTH AND SHORT-RUN FLUCTUATIONS
 Both the PPC model and the AD-AS
model can help us distinguish
between long-run growth and short-
run fluctuations due to the business
cycle.

17. DISTINGUISHING BETWEEN LONG-RUN
GROWTH AND SHORT-RUN FLUCTUATIONS
 The points along the PPC are
achievable if there is efficient use of
the economy’s resources.
 If the economy experiences a
macroeconomic fluctuation due to
the business cycle, production falls to
a point inside the PPC.
 On the other hand, long-run growth
will appear as an outward shift of the
PPC curve.

18. DISTINGUISHING BETWEEN LONG-RUN
GROWTH AND SHORT-RUN FLUCTUATIONS

19. DISTINGUISHING BETWEEN LONG-RUN
GROWTH AND SHORT-RUN FLUCTUATIONS
 In the AD-AS model, fluctuations of
actual aggregate output around
potential output are indicated by
shifts of AD or SRAS that result in
short-run macroeconomic equilibrium
above or below potential output.
 In this case, adjustments in nominal
wages will eventually bring the
equilibrium level of real GDP back to
the potential level.

20. DISTINGUISHING BETWEEN LONG-RUN
GROWTH AND SHORT-RUN FLUCTUATIONS
 Long-run economic growth is
represented in the AD-AS model as a
rightward shift of the LRAS curve.
 This corresponds to an increase in
the economy’s level of potential
output.

21. DISTINGUISHING BETWEEN LONG-RUN
GROWTH AND SHORT-RUN FLUCTUATIONS