The causes of economic growth

Overview

Investment in physical capital raise the growth rate, human capital and how does investment in it cause growth and discovery or development of natural resources contribute to growth.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   How does an increase in the quantity of labour raise the economy's potential output?

   Model answer

   Labour is a factor of production, so a larger workforce allows more output to be produced, shifting the production possibility frontier outwards and the long-run aggregate supply curve to the right. The labour input can be increased by growth in the working-age population, by net inward migration, by higher participation among groups with low rates such as older workers and those with caring responsibilities, and by longer working hours. Note that increasing the labour input raises total output but raises output per head only if the additional workers are at least as productive as the existing workforce.

2. 2

   How does investment in physical capital raise the growth rate?

   Model answer

   Investment adds to the stock of machinery, equipment, buildings and infrastructure, so each worker has more and better capital to work with and produces more per hour. Potential output therefore rises and the long-run aggregate supply curve shifts right. Investment has a second effect in the short run, because spending on capital goods is itself a component of aggregate demand, so it shifts AD right as well. The long-run effect depends on net investment exceeding depreciation, since replacing worn-out equipment maintains the capital stock rather than enlarging it.

3. 3

   What is human capital and how does investment in it cause growth?

   Model answer

   Human capital is the stock of skills, knowledge, health and experience embodied in the workforce, which determines how productive each worker is. Investment in it through education, training and healthcare raises output per worker without any increase in the number of workers or the hours they work. Potential output rises and long-run aggregate supply shifts right. The returns are long delayed, since a person educated now contributes over a working lifetime, which is why the effect on measured growth appears many years after the spending.

4. 4

   Why is technological progress regarded as the most important long-run source of growth?

   Model answer

   Adding more labour and capital eventually runs into diminishing returns, since each additional unit of capital added to a given workforce yields a smaller increase in output than the last, so growth from accumulation alone must slow. Technological progress raises the output obtainable from a given quantity of inputs, so it is not subject to that limit and can raise living standards indefinitely. It also raises the return to investment, which encourages further capital accumulation. This is why economies that stop innovating stagnate even while continuing to invest.

5. 5

   How does the discovery or development of natural resources contribute to growth, and what qualification applies?

   Model answer

   Natural resources are a factor of production, so bringing new reserves into use raises potential output and shifts the production possibility frontier outwards, generating export earnings and tax revenue as well. The qualification is that resource-based growth is not automatically sustainable, since extraction depletes the stock and the output must eventually fall. There is a further risk that resource earnings raise the exchange rate, which damages the competitiveness of other export industries, so growth in one sector is bought partly at the expense of others.

6. 6

   How do improvements in infrastructure raise the growth rate?

   Model answer

   Transport, energy and communications networks reduce the cost of moving goods, people and information, so firms across the whole economy can produce and distribute more cheaply. The effect is economy-wide rather than confined to one industry, and it raises the return on private investment by making previously unviable projects worthwhile. Better transport also widens the area within which people can seek work, reducing geographical immobility. Long-run aggregate supply shifts right and the production possibility frontier moves outwards.

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