The AD/AS model GapFill

While we have explored how economic growth is measured, it is important to be able to explain growth in macroeconomic terms, and understand its effect on the wider economy.

There are three primary reasons why economic growth takes place. The first is due to the major components of  export-led growthimport substitutionaggregate demandthe factors of production: investment, consumption and government. The second is through expansion or improvements in  export-led growththe factors of productionimport-substitutionaggregate demand: labour, land, capital and enterprise. The third is often associated with developing countries:   export-led growththe factors of productionimport-substitutionaggregate demand, in which the economy is expanded through mass domestic production for global markets.

Alongside actual growth, as measured by GDP, we can also identify potential growth in an economy. Potential growth refers to actual growth plus spare economic capacity. When potential growth exceeds actual growth it is known as  lost national incomea budget surplusa balance of paymentsan output gap.

While it is very difficult to measure potential growth accurately, there are some ways of indicating where the level of potential growth may lie. One strong indication of potential growth exceeding actual growth might be high  inflationgovernment debtinterest ratesunemployment. Conversely, it is possible for the economy to be performing at overcapacity. A strong indication of this could be high  taxationunemploymentinterest ratesinflation.

It is important to remember that the  Keynesianclassicalmonetaryfiscal tradition in economics regards potential growth exceeding actual growth as only possible in relation to short-run economic phenomena. In contrast, the  Keynesianfiscalclassicalmonetary tradition contends that it can also happen in the long run.