Understanding economic growth | AP Macroeconomics | Khan Academy

In this video, we're going to talk about economic growth. I want to be very careful here because, depending on the context, people, including economists, might mean different things by economic growth.

In everyday language, when people are talking about economic growth, they're usually just talking about an expansion in the output of an economy over time. So, if real GDP is increasing, they might consider that to be economic growth. But the context that we're going to talk about in this video—this is one that you might see in an introductory economics class or an AP economics class—is that we aren't just talking about an increase in real GDP over time. We are talking about an increase in the full employment output over time, regardless of where we are in the economic cycle.

So, keep that in mind as you watch this video. If we're just talking about the increase of real GDP, we're going to call that an expansion, not necessarily economic growth. We're going to call real GDP decreasing as being equal to a contraction.

When we talk about economic growth, we're actually talking about the full employment output increasing. This could happen somewhat independently of where we are in the actual economic cycle. Let's do a little diagram to make that a little bit clearer.

Right over here, I have plotted real GDP of an economy versus time. What you see here in yellow is how the real GDP is fluctuating, and it's fluctuating around its full employment output. Let's pick this time right over here and call it t sub 1. So, right at this point, that is our full employment output—let's call it y sub f sub 1.

But we see that our economy is performing above our full employment output. We have a positive output gap. If we go from that point in time and fast forward a little bit to t2, so let's go to t sub 2 here. Because the y sub f right over here—the full employment output—right here is flat, according to this, we would not have experienced any economic growth from t sub 1 to t sub 2, even though the real GDP would have grown. We would have grown from this point to this point right over here.

So, one way to think about it is we are expanding as long as this curve is upward sloping. But if the full employment output is not changing, we are not experiencing economic growth. The times when we actually are experiencing economic growth are times when our full employment output is changing.

So let’s say from this time right over there to this time right over there. Notice that this is happening theoretically during a contraction. This is a contraction right over here where real GDP is actually pulling back. But if we knew truly what the full employment output were and were able to plot it like this, theoretically, we actually are experiencing economic growth here despite a contraction.

To appreciate this, let's look at other models that we have studied in economics. So we think about a production possibilities curve. The ones that we typically see only have two goods or services. A real economy is going to be much more complex; it would have millions of goods and services. But it's very hard to draw a million-dimension production possibilities curve.

What this shows us is, at a snapshot in time, what is the full employment output, and it shows us the trade-off between these two goods or services. Now, if we're in a situation where we're behind the production possibilities curve, that is a negative output gap. It's possible that over time we go from this negative output gap back to the production possibilities curve. That would be an expansion in the economy.

But by the definition that we’re talking about here—which is not what is typically talked about in the news or something like this—we would not call that economic growth. Economic growth happens when we push out the production possibilities curve. When we have an increase in our full employment output, economic growth is realized maybe through some new technology or more workers or resources, or just better institutions.

We’re able to push our production possibilities curve out. This is an example of economic growth. So, for example, this could be our production possibilities curve at let's say t3, where this is t sub 3 right over here. Then this is our production possibilities curve at t sub 4, where this is t sub 4 right over here, where our full employment output has increased.

We can also think about the same idea using our aggregate demand or aggregate supply model. When we study that, we saw that in the short run—because of say, a demand shock or a supply shock—we could be operating to the left or the right of our full employment output, creating these positive or negative output gaps. But over time, we're going to gravitate back to this full employment output.

As long as our production possibilities curve isn't getting pushed out, isn't changing, or as long as our long-run aggregate supply curve is not changing—according to the definition that I'm talking about in this video—we are not seeing economic growth. The analog for what we saw in this PPC curve is maybe this is the long-run aggregate supply curve at t3. But if our economy has more resources—maybe more population, more natural resources, better technology, better institutions—maybe it's able to produce more at full employment.

In that situation, our long-run aggregate supply curve would shift to the right. So this could be our long-run aggregate supply curve at time t4. This is full employment output; let's call that sub 3. This would be full employment output sub 4.

The big takeaway here is, regardless of where we are in the expansion or contraction of our business cycles, economic growth is the change in that blue line. If we're looking at the PPC, it's a shift out of our PPC of our production possibilities curve. If we're looking at the aggregate demand-aggregate supply model, it is a shift to the right of our long-run aggregate supply curve.

Once again, what are the things that can cause that? These are good to know: a notion of capital. Traditionally, people have just thought, "Hey, more factories, more resources, more land—maybe that will push things out," and it definitely could.

But more modern definitions are thinking human capital. Hey, if we have a better educated workforce, a more skilled workforce, that can also matter. People also think about things like technology. If we can discover better ways of putting together the resources we have, that can also increase our productivity, and that's what we would call technology in an economics context.

Things like institutions matter as well. You could imagine if your bureaucracy really slows things down—if it takes forever to get a permit to do something—that might put a hamper on what the full employment output is. But if the institutions become much more efficient, then that might allow the country, allow that economy, to produce more at full employment.

So, all of these things could push out your PPC, could push your long-run aggregate supply curve to the right, or cause this blue curve—which represents your full employment output—to move up over time. All of that would be economic growth.