Economic Growth: How to Raise a Nation's Potential Output

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  • 0:03 Economic Growth
  • 3:13 Advantages of Economic Growth
  • 4:45 Illustrating Economic Growth
  • 6:16 Lesson Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

Learn the truth about long run economic growth, including how economists define and illustrate an increase in the potential output of a nation through change in real GDP.

Economic Growth

Let's talk about economic growth. I want you to go with me to the town of Ceelo, where Bob the lawn guy is sitting in his easy chair in front of the television. Bob has been downing a few too many chocolate shakes every week and needs to get on an exercise program. After considering all his options, such as going to the gym or buying the brand new Ab-Destroyer he just saw on TV last night, Bob decides to take off running in his neighborhood. Besides, he says to himself, 'Maybe the neighbors will see my new Bob's Lawn Service t-shirt and sign-up as a new customer, so I can pay for that Ab-Destroyer in one payment instead of three easy payments of $9.99.'

When Bob starts out running, he's not in great shape, as evidenced by how short of a distance he can run before passing out. But after a few days of jogging, Bob notices he can run farther. What happened? Bob increased his potential output. He can run farther. Potential output is a long-run thing (please pardon the pun).

Let's say that on day one, Bob can run a mile in 15 minutes. (Ouch! That's a really long time.) That's his limit. But he can only reach a mile within 15 minutes if he paces himself. Now suppose that on day two he can run a mile in seven minutes instead of 15. That means his long-run potential just increased.

Keep in mind that he can only run a mile in seven minutes when he paces himself. Whether it's day one or day two, Bob can only reach his long-run potential at a certain pace. Although he is capable of running faster than his regular pace during the first five minutes of his run, this can only happen for a very short amount of time, or else he'll get exhausted too early and won't reach his long-run potential. Likewise, if Bob slows down below his usual pace for the first five minutes, he'll have to speed up in order to reach his long-run potential.

The economy is a lot like a long-distance runner. It has a long-run potential. When everyone is working and using all the tools they have available, there is a limit to what an economy can produce. Although it's possible for an economy to grow faster than its regular pace in the short-run, say for a quarter or a year, eventually, it tends to return to its long-run potential.

Graph showing economic growth as an outward shift of the production possibilities curve
Economic Growth Outward Shift Graph

Just like a runner is concerned about their long-run potential, governments and central bank leaders, with the help of economists, are most concerned about helping the economy increase its long-run potential.

When the economy grows, that means it can produce more. Another way to say it is: the economy's potential output has increased. Economic growth is when an economy's long-run potential output increases.

Advantages of Economic Growth

Economic growth has many advantages, but the most obvious ones include a higher standard of living and lower unemployment.

When an economy grows faster than the population grows, its standard of living will increase. That means people like Bob can live in nicer houses, enjoy more material wealth and buy that new Ab-Destroyer to help him develop a six-pack.

Economic growth usually means more jobs and lower unemployment. For example, when the economy is growing at a solid pace over time, Bob's lawn business tends to have more customers and needs more workers to meet the demand for lawn services in his area.

It's important to note that economic growth happens over time. It's a process, not a single event. In the short-run, economic growth is measured in terms of the percentage change in real gross domestic product, or real GDP. When you hear on television that the economy grew two percent or five percent over the last year, let's say, then that's talking about short-term growth. Again, this is how fast the economy actually grew over the last 12 months. But economic growth is really talking about the economy's long-run potential. That's like saying that Bob was going 10 miles per hour for the last minute of his run, but he averaged seven miles per hour over his two-mile run.

Illustrating Economic Growth

Economic growth shown as a rightward shift in the long-run aggregate supply curve
Economic Growth Rightward Shift Graph

Economists illustrate long-run economic growth in two important ways. Firstly, as an outward shift of the production possibilities curve, which looks like this.

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