OxfordAQA International AS and A-level Economics: Economic growth and the cycle (9640)

This study guide covers OxfordAQA International AS and A-level Economics (9640), specification section 3.2.3.1, Economic growth and the economic cycle. It follows the OxfordAQA specification, version 1.2, for International AS exams from May/June 2021 and International A-level exams from May/June 2022. Section 3.2 is International AS content, so this material is part of the AS and is carried into the A-level. All data below are invented and labelled as illustrative.

Use it with the revision notes and the practice questions. Related pages: Measurement of macroeconomic performance and the macroeconomic performance revision notes. Course pages: the OxfordAQA Economics hub and the printable checklist. To find weak spots first, try the free diagnostics.

What the specification asks for

Outcome in 3.2.3.1	What you must be able to do
Short-run and long-run growth	Explain the difference; show it on a production possibility diagram and an AD/AS diagram
Determinants of growth	Explain demand-side and supply-side causes of short-run growth and of the long-run trend rate
The economic cycle	Use real GDP, the rate of inflation, unemployment and investment to identify phases
Output gaps	Distinguish positive from negative gaps
Shocks	Explain how demand-side and supply-side shocks, at home and abroad, affect the economy

Quantitative skills (3.5) can be tested anywhere: percentage change (QS2), index numbers (QS5), and real versus money values (QS7) all appear below.

1. Short-run and long-run growth

Economic growth means more real national output. Always use real GDP, because nominal GDP can rise purely through higher prices.

• Short-run growth is a rise in actual real GDP. It usually comes from higher aggregate demand (AD) using up spare capacity, or from a fall in costs that shifts short-run aggregate supply (SRAS).
• Long-run growth occurs when the productive capacity of the economy is increasing. It is measured by the underlying trend rate at which real output grows.

Two diagrams show the difference.

Diagram	Short-run growth	Long-run growth
Production possibility diagram (capital goods on one axis, consumer goods on the other)	Movement from a point inside the boundary towards it, as unemployed resources are used	Outward shift of the whole boundary
AD/AS diagram (price level on the vertical axis, real GDP on the horizontal)	AD shifts right along SRAS; real GDP rises from Y1 to Y2	LRAS shifts right, from LRAS1 to LRAS2

In words: draw a vertical LRAS1 at potential output, an upward-sloping SRAS and a downward-sloping AD. Short-run growth is AD moving right along SRAS to a higher equilibrium. Long-run growth is LRAS1 moving right to LRAS2, with SRAS following it.

The vertical LRAS curve marks the normal capacity level of output. The specification notes the Keynesian view that an economy can stay well below this level for many years, so spare capacity is not always used up quickly.

Worked example: real versus money growth. In Country A (illustrative), nominal GDP rises from 5,000 to 5,330 while the price index moves from 100 to 104.

Nominal growth = (5,330 - 5,000) / 5,000 = 6.6%
Real GDP, new year = 5,330 / 104 x 100 = 5,125
Real growth = (5,125 - 5,000) / 5,000 = 2.5%

Subtracting 4% from 6.6% gives 2.6%, which is close but not exact. Dividing gives the exact result: 1.066 / 1.04 = 1.025.

Worked example: the trend rate. Country A’s real output rises from 1,800 to 2,160 over six years.

Total growth = 2,160 / 1,800 = 1.20
Average annual (compound) rate = 1.20^(1/6) - 1 = 3.09%

A simple average (20% / 6 = 3.33%) overstates it because growth compounds. If the trend rate were 3% and potential output started at 1,800, it would reach 1,800 x 1.03^6 = 2,149 after six years.

2. Determinants of growth

Split causes by what they change.

Demand-side determinants (shift AD, mainly short-run):

• Consumption: confidence, interest rates, wealth, taxes on income.
• Investment: interest rates, business confidence, expected profit, the rate of growth itself.
• Government spending and taxation.
• Net exports: foreign incomes, the exchange rate, relative prices.

Supply-side determinants (shift SRAS in the short run and LRAS in the long run):

• Costs: money wage rates, raw material prices, indirect taxes, productivity.
• Capacity: the capital stock, technology, the size and skills of the working population, factor mobility, enterprise, attitudes and economic incentives.

Worked example: contributions to growth. Country A’s real GDP is 1,200. During a year, consumption rises by 18, investment by 12, government spending by 6, and net exports fall by 6.

Change in real GDP = 18 + 12 + 6 - 6 = 30
Growth = 30 / 1,200 = 2.5%
Contributions (percentage points): C 1.5, I 1.0, G 0.5, net exports -0.5

Chain of reasoning. Lower interest rates make borrowing cheaper, so investment and consumption rise. AD shifts right. If the economy has spare capacity, output rises with a small rise in the price level. If it is near capacity, most of the rise appears as higher prices. So the effect of a demand stimulus on real growth depends on how close output is to potential.

Evaluation. Demand-side policies can speed up short-run growth but cannot lift the trend rate unless they also raise investment, which raises capacity. Supply-side improvements raise the trend rate but usually take years to work. A balanced answer says which is more relevant to the economy described, using the evidence in the data.

3. Output gaps

Potential output is the level of real GDP the economy can sustain when its resources are normally employed. It is the position of the vertical LRAS curve.

• A positive output gap: actual real GDP sits above what the economy can produce at normal capacity.
• A negative output gap: actual real GDP sits below that level.

Output gap (%) = (actual real GDP - potential real GDP) / potential real GDP x 100

Worked example. Country B (illustrative) has potential output of 840.

Actual real GDP	Calculation	Gap
861	(861 - 840) / 840	+2.5%
806.4	(806.4 - 840) / 840	-4.0%

A positive gap usually brings inflationary pressure, because firms bid for scarce labour and materials and operate above normal capacity; unemployment is likely to be low. It tends to pull in imports. A negative gap means idle resources, higher cyclical (demand-deficient) unemployment and downward pressure on inflation.

Evaluation points. Potential output cannot be observed directly, so gaps are estimates and get revised. A gap measured in one year says nothing certain about the next. Also, growth and the gap are different things: if potential grows 3% a year, actual growth of 2% still widens a negative gap, even though real GDP is rising.

4. The economic cycle

The economic cycle is the repeated rise and fall of actual real GDP around its trend. It passes through phases: boom, slowdown, recession and recovery, with the trough as the lowest point between recession and recovery. A common definition of recession is two consecutive quarters of falling real GDP.

Indicator	Boom	Slowdown	Recession	Recovery
Real GDP growth	Well above trend	Positive but falling	Negative	Rising, may be below trend at first
Inflation	Rising	Peaks, then eases	Falling	Low, starting to rise
Unemployment	Low or falling	Near its lowest	Rising	Still high, then falling
Investment	Strong growth	Slowing	Falling sharply	Starting to rise

Worked example: reading the cycle. Country M (illustrative) has a trend growth rate of 3%.

Year	Real GDP growth	Inflation	Unemployment	Investment change	Phase
1	+4.5%	3.8%	5.0%	+12%	Boom
2	+2.0%	4.2%	4.8%	+3%	Slowdown
3	-1.6%	2.9%	5.9%	-14%	Recession
4	+1.2%	1.5%	7.1%	-2%	Trough
5	+3.9%	1.7%	6.8%	+9%	Recovery

Notice the timing. In year 2, growth has slowed, yet inflation is higher than in year 1 and unemployment is at its lowest. Both lag real GDP. In year 4, output grows again but unemployment is at its highest. Investment moves the most, because firms respond strongly to changes in growth and confidence. Use several indicators together; one indicator on its own can mislead.

5. Demand-side and supply-side shocks

A shock is a sudden, unexpected event that shifts AD or SRAS. It may start at home or abroad.

Shock	Examples	AD/AS effect	Result
Negative demand-side	Collapse in confidence, fall in asset prices, global recession cutting export orders	AD shifts left	Lower output, lower price level, negative gap
Positive demand-side	Surge in export orders, sharp rise in confidence	AD shifts right	Higher output, higher price level, may create positive gap
Negative supply-side	Rise in imported raw material prices, natural disaster damaging output	SRAS shifts left	Lower output and higher price level
Positive supply-side	Fall in raw material prices, a new technology	SRAS shifts right (LRAS if lasting)	Higher output and lower price level

Global transmission. Events abroad reach the domestic economy through export demand, the price of imported inputs, exchange rates, and confidence.

Worked example. Exports in Country C (illustrative) are 300, which is 30% of its GDP of 1,000. Its trading partners fall into recession and its exports drop 5%.

Fall in exports = 5% x 300 = 15  (1.5% of GDP)
If the multiplier is 2: fall in GDP = 15 x 2 = 30  (3.0% of GDP)

A country that depends heavily on exports is exposed to this kind of shock. A less open economy would feel less.

Evaluation. The size of the effect depends on how large and how long-lasting the shock is, how open the economy is, how much spare capacity exists, how flexible wages and prices are, and the government’s response. A temporary supply shock may leave capacity unchanged. A deep recession that scraps firms and leaves workers jobless for long periods can reduce capacity, shifting LRAS left.

Common errors

• Describing a rise in nominal GDP as growth.
• Drawing AD shifting right and calling it long-run growth. Long-run growth needs LRAS or the boundary to shift.
• Treating a falling growth rate as a falling level of output. Slowdown is not recession.
• Subtracting inflation from nominal growth and presenting it as exact.
• Giving a list of shocks without tracing the AD or SRAS shift to output and prices.

Official syllabus

OxfordAQA International AS and A-level Economics (9640), specification version 1.2, section 3.2.3.1, first teaching September 2020, published by OxfordAQA.