Why policy can change long-run growth
In Topic 5.6 you measured economic growth as the growth rate of real GDP per capita, and you saw that it comes from more and better resources and better technology. This topic asks the next question: what can a government do to make that happen faster?
Start with a simple identity. Real GDP per capita is real GDP divided by the population. Multiply and divide by the number of people employed:
Real GDP per capita = (real GDP ÷ employed workers) × (employed workers ÷ population)
- The first part is output per worker, the measure of average labour productivity.
- The second part is the share of the population that is employed. It rises when more adults join the labour force (higher labour force participation) and find jobs.
So a government has two routes to higher real GDP per capita:
- Raise productivity: make each worker able to produce more.
- Raise labour force participation: make it easier or more rewarding for adults to work.
For small changes, the growth rate of real GDP per capita is close to the growth rate of productivity plus the growth rate of the employed share.
Policies that raise either part increase the economy’s capacity. In the models you know, that means the LRAS curve shifts right and the PPC shifts outward. This is different from stabilization policy in Topics 5.1–5.5, which mainly moves AD to close an output gap.
Policies that raise productivity or participation
Productivity depends on technology and on the amount of physical capital and human capital each worker has. Participation depends on the incentives and barriers adults face when deciding whether to work.
| Policy | Main channel | Why capacity grows |
|---|---|---|
| Public spending on schools, universities and vocational training | Human capital | Better-skilled workers produce more per hour |
| Public health programmes | Human capital, participation | Healthier workers are more productive and lose fewer working days |
| Roads, ports, power grids, broadband (infrastructure) | Physical capital | Firms move goods and information faster and at lower cost |
| Funding for research, grants for new technology, strong patent protection | Technology | New methods let the same inputs produce more |
| Lower taxes on business investment, faster tax write-offs for new equipment | Physical capital | Firms buy more machines, so each worker has more capital |
| Incentives to save (for example, tax-free savings accounts) | Physical capital | More saving supplies more loanable funds for investment |
| Subsidised childcare, flexible-work rules | Participation | Parents who would stay at home can join the labour force |
| Lower marginal tax rates on income from work | Participation, hours | Each extra hour of work pays more after tax |
Notice that infrastructure and technology are areas where government often invests directly. Private firms may underinvest in them, because a road or a basic scientific discovery benefits many people who do not pay for it.
Our fictional economy: Valdoria
Valdoria is the fictional country used across the Marlbridge macroeconomics pages. Its currency is the valda (VD). All data are fictional. In the year studied, the economy is at full employment.
| Item | Value |
|---|---|
| Population | 40.0 million |
| Working-age population | 32.0 million |
| Labour force participation rate | 62.5% |
| Unemployment rate (the natural rate) | 5.0% |
| Output per employed worker | VD 48,000 |
Worked example 1: participation or productivity?
Question. (a) Calculate Valdoria’s labour force, employment, real GDP and real GDP per capita. (b) Policy A (subsidised childcare) raises the participation rate to 65.0%; unemployment stays at 5.0% and output per worker is unchanged. Calculate the new real GDP per capita and its growth rate. (c) Policy B (a national training programme) raises output per worker by 5%, with participation unchanged at 62.5%. Calculate the new real GDP per capita and its growth rate. (d) The government adopts both policies. Calculate the growth in real GDP per capita. (e) With Policy B only, the population grows by 2% while employment stays the same. What is the growth in real GDP per capita now?
(a) Labour force = 32.0 million × 0.625 = 20.0 million. Employed = 20.0 million × 0.95 = 19.0 million. Real GDP = 19.0 million × VD 48,000 = VD 912 billion. Real GDP per capita = 912 billion ÷ 40.0 million = VD 22,800.
Check with the identity: 48,000 × (19.0 ÷ 40.0) = 48,000 × 0.475 = VD 22,800.
(b) Labour force = 32.0 × 0.65 = 20.8 million. Employed = 20.8 × 0.95 = 19.76 million. Real GDP = 19.76 million × 48,000 = VD 948.48 billion. Real GDP per capita = 948.48 billion ÷ 40.0 million = VD 23,712. Growth = (23,712 − 22,800) ÷ 22,800 × 100 = 4.00%.
Output per worker did not change. Real GDP per capita rose only because a larger share of the population is working.
(c) Output per worker = 48,000 × 1.05 = VD 50,400. Real GDP = 19.0 million × 50,400 = VD 957.6 billion. Real GDP per capita = 957.6 billion ÷ 40.0 million = VD 23,940. Growth = 5.00%.
(d) Real GDP = 19.76 million × 50,400 = VD 995.904 billion. Real GDP per capita = VD 24,897.60. Growth = (24,897.60 − 22,800) ÷ 22,800 × 100 = 9.20%. Check: 1.04 × 1.05 = 1.092. Adding the two rates (4% + 5% = 9%) is a close shortcut.
(e) Population = 40.0 × 1.02 = 40.8 million. Real GDP per capita = 957.6 billion ÷ 40.8 million = VD 23,470.59. Growth = 2.94%, close to the shortcut 5% − 2% = 3%.
Interpretation. Both policies raise Valdoria’s capacity, so both shift LRAS to the right. Part (e) shows why growth is measured per capita: real GDP rose by 5%, but each person’s share rose by less than 3% because the population also grew.
Government investment in infrastructure and technology
When the government builds a port or funds research, the effect comes in two stages.
- Short run: demand. The spending is part of government purchases (G). AD shifts right, with a multiplier effect (Topic 3.2). The new port is not yet working.
- Long run: supply. Once the port, the power plant or the new technology is in use, firms can produce more with the same workers. Productivity rises, so LRAS shifts right (and the PPC shifts out).
The same is true of public education. A new school year raises G at once, but it raises the skills of the labour force only years later.
Supply-side fiscal policy
Supply-side fiscal policies are changes in taxes, government spending or the rules attached to them that are designed to change incentives for households and firms, so that people choose to work more, save more, invest more or innovate more. The aim is to raise aggregate supply and potential output (full-employment output, Yf), not only aggregate demand.
Examples:
- cutting marginal income tax rates, so each extra hour of work keeps more of its reward;
- lowering taxes on business investment or on the return to saving;
- tax relief for research and development spending;
- changing transfer payments so that taking a job does not mean losing most of the benefit at once.
How a supply-side tax cut works in each run. Take a cut in marginal tax rates on income from work.
- Short run, AD. Households keep more of their income, so disposable income and consumption rise. AD shifts right.
- Short run and long run, AS. Over time, the better reward for work raises participation and hours, and lower taxes on saving and investment raise the capital stock. Costs per unit of output fall and capacity grows: SRAS and LRAS shift right.
- Result. Real output and potential output rise. The effect on the price level is ambiguous: AD shifting right pushes it up, AS shifting right pushes it down.
Worked example 2: short run or long run?
Question. Valdoria is in long-run equilibrium at full employment. For each policy, state the short-run effect on AD and the long-run effect on LRAS, and say whether it is likely to raise long-run growth. (a) A one-off cash payment to every household. (b) A cut in the tax rate on the interest people earn from saving. (c) Government building of a high-speed rail line between the two largest cities. (d) Reforming unemployment benefits so they are withdrawn gradually as a person’s earnings rise, instead of all at once on the day they start work.
(a) AD shifts right in the short run (more disposable income, more consumption). It does not change anyone’s reward for working, saving or investing, so LRAS does not shift. Starting at full employment, the long-run result is a higher price level and the same real output. No lasting growth.
(b) In the short run the effect on AD is small (if anything, households may spend a little less as they save more). Saving rises, the supply of loanable funds shifts right, the real interest rate falls and private investment rises. More capital per worker raises productivity: LRAS shifts right. Raises growth, mainly in the long run.
(c) Building the line raises G: AD shifts right in the short run. Once it runs, people and goods move faster, so productivity rises: LRAS shifts right. Raises growth.
(d) Taking a job now raises a person’s total income by more, so more people choose to work: participation rises and LRAS shifts right. Any short-run effect on AD is small. Raises growth through participation, the route of Policy A in Worked example 1.
Check. The test is always the same: does the policy raise the quantity or quality of resources, or technology? If it only changes spending, it is a stabilization tool, not a growth policy.
Trade-offs and limits
Growth policies are not free.
- Opportunity cost now. Resources used to build capital goods (machines, rail lines, schools) are not available for consumer goods today. On a PPC with capital goods and consumer goods, choosing a point with more capital goods means fewer consumer goods now, but a larger outward shift later (Figure 2).
- Crowding out. If a tax cut or new public investment is financed by government borrowing, the demand for loanable funds rises, the real interest rate rises and private investment falls (Topic 5.5). This reduces the capital stock and offsets part of the growth the policy aimed for.
- Time lags. Training and research take years to pay off. In the meantime the main effect is on AD.
- Uncertain responses. How much people change their work, saving or investment after a tax change is an empirical question. The model tells you the direction, not the size.
Scope note. You need to explain the direction of these effects with graphs and words. The course does not ask you to estimate how large incentive effects are, or to judge one country’s actual tax system.
Common misconceptions
- “Any fiscal stimulus raises long-run growth.” Only policies that raise capacity do. A demand boost at full employment ends as a higher price level.
- “Supply-side policy only shifts AS.” A tax cut or public investment also shifts AD right in the short run. Show both curves.
- “A supply-side tax cut always lowers the price level.” The price-level effect is ambiguous because AD and AS both shift right.
- “Growth means a rise in real GDP.” Growth is measured per capita. If population grows faster than real GDP, real GDP per capita falls.
- “More people working cannot raise GDP per capita unless productivity rises.” Higher participation raises the employed share of the population, so real GDP per capita rises even with output per worker unchanged.
- “Public investment is always pure gain.” It has an opportunity cost, and if it is financed by borrowing it can crowd out private investment.
- “Infrastructure shifts LRAS as soon as the money is spent.” Spending shifts AD first; LRAS shifts when the new capital is in use.
- Shifting SRAS but forgetting LRAS. A lasting rise in capacity moves LRAS (and the PPC); a shift in SRAS alone is a short-run cost change.
Where this leads
This topic ends Unit 5. Unit 6 opens the economy to the rest of the world, starting with how a country records its trade and financial flows: continue with Topic 6.1, Balance of Payments Accounts. If the measurement of growth is not yet secure, go back to Topic 5.6, Economic Growth.
Now try the practice questions, then use the revision notes and the checklist to consolidate.
Quick questions
Is every expansionary fiscal policy a growth policy?
No. A rise in spending or a tax cut that only raises AD changes output in the short run. If the economy is at full employment, the long-run result is a higher price level, not more output. A policy raises long-run growth only if it raises the economy's capacity.
What happens to the price level after a supply-side policy?
It depends on the sizes of the shifts. AD shifts right, which pushes prices up; SRAS and LRAS shift right, which pushes prices down. Without numbers, say the price level could rise, fall or stay the same, but real output rises.