Chapter 11 · Macroeconomic objectives II: Economic growth, sustainable level of debt
Long-run economic growth: monetarist/new classical
Use a rightward LRAS shift to explain long-run economic growth. Connect greater productive capacity to changes in resources and productivity.
The economic idea
Economic growth is an increase in real output over time. Long-run or potential economic growth is an increase in the economy’s productive capacity, allowing a higher sustainable level of real GDP.
In the monetarist/new classical model, LRAS is vertical at potential output because long-run real output is determined by the quantity, quality and productivity of factors of production rather than the average price level. Investment, human capital, labour-force growth, technology and better institutions can shift LRAS right.
SRAS also shifts right when the same productive improvements reduce unit costs or allow more output at each price level. With AD held constant, the model isolates a supply-led increase in sustainable real output and downward pressure on the price level.
Growth can improve debt sustainability by enlarging the income and tax base relative to outstanding debt. However, borrowing is sustainable only if the government can service it without default, implausibly large future adjustment or persistent harm to essential spending and growth. The interest rate, nominal GDP growth, maturity, currency and primary fiscal balance all matter.
Reading the capacity shift from LRAS₁ to LRAS₂
“Price level” is on the vertical axis and “Real GDP” is on the horizontal axis.
“LRAS₁” and “LRAS₂” mark the original and current levels of potential output. “SRAS₁” and “SRAS₂” show the corresponding short-run supply conditions.
“AD” is held fixed. “E₁” and “E₂” show where that same planned expenditure meets the two supply conditions.
Original capacity: Yp₁
“E₁” lies on the original supply boundary and records original potential output “Yp₁” with price level “Pl₁”.
Capacity change: LRAS₁ to LRAS₂
“LRAS₂” lies to the right of “LRAS₁”. Potential output rises from “Yp₁” to “Yp₂”. The current state shows long-run potential growth.
New equilibrium: E₂
“AD” intersects the new supply boundary at “E₂”. The graph shows potential output at “Yp₂” and the price level at “Pl₂”; with AD fixed, the price level falls.
Connect investment to capacity, not just spending
Investment can affect the economy in two ways. Buying capital goods adds to aggregate demand now; productive new equipment can increase the capital stock and potential output later. Explain which effect the question and diagram show.
An outward LRAS shift represents greater productive capacity. Whether actual output reaches that capacity also depends on demand and adjustment. The diagram does not prove that the benefits are shared equally or that the growth is environmentally sustainable.
From productive investment to an outward LRAS shift
Investment, skills, technology, labour-force growth or institutional improvement increases the quantity, quality or productivity of resources.
Potential output moves from “LRAS₁” to “LRAS₂”, while lower unit costs move short-run supply from “SRAS₁” to “SRAS₂”.
With “AD” unchanged, the economy reaches “E₂” at a higher sustainable output and a changed price level.
Common mistakes to avoid
- A shift from “LRAS₁” to “LRAS₂” is potential growth; it is not merely movement toward unchanged capacity.
- Do not shift “LRAS₂” without explaining the corresponding resource or productivity change.
- Higher total real GDP does not necessarily mean higher real GDP per capita or improved welfare.
- The diagram does not plot debt, interest payments or fiscal balances and cannot by itself prove debt sustainability.
How to draw this diagram
- Title the diagram “Long-run economic growth: monetarist/new classical”. Label the horizontal axis “Real GDP” and the vertical axis “Price level”.
- Draw AD first and label it clearly.
- Draw SRAS₁ next and label it clearly.
- Draw LRAS₁ next and label it clearly.
- Draw SRAS₂ next and label it clearly.
- Draw LRAS₂ next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Project important intersections to the axes with dashed guide lines and label the outcomes.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The diagram does not show the time lags or uncertainty surrounding productivity and investment.
- Aggregate potential output is estimated rather than directly observed.
- Higher real GDP may coexist with inequality, environmental damage or slower per-capita growth.
- The model assumes the supply improvement is compatible with both short-run cost conditions and long-run capacity.
- Public debt and debt service are not axes or curves in this model; they require separate fiscal analysis.