Productivity and Growth drives long-run growth, and growth shows up as rightward shifts of LRAS and outward shifts of the PPC. Which policies can speed it up?
Key idea
Policies that build physical capital, human capital and technology, or that improve the institutions that support them, raise potential output: they shift LRAS (and the PPC) outward. Policies that only raise spending shift AD; they do not raise potential output unless they add to the economy's capacity to produce.
Why it works
Potential output depends on what the economy has to work with and how well it uses it. A tax rebate spent on consumer goods raises demand for a while, but leaves the economy with the same machines, skills and ideas. Building a port does both: the construction spending raises AD now, and the finished port lets firms produce and ship more later. Economists broadly agree on the sources of growth; they debate which particular policies deliver them best and at what cost.
| Policy | Effect |
|---|---|
| Funding basic research; protecting patents and property rights | LRAS right |
| Better schools and job training | LRAS right |
| Investment tax credit; building roads and ports | AD now, LRAS later |
| One-time tax rebate spent on consumer goods | AD only |
Worked examples
Worked example: Demand or capacity?
Classify: (a) more funding for engineering schools; (b) a temporary rise in consumer confidence; (c) a new highway network.
- (a) More human capital: LRAS shifts right.
- (b) More spending, no new capacity: AD only.
- (c) Construction spending raises AD now; the highways add capital, raising LRAS later.
Answer: (a) LRAS; (b) AD only; (c) both
Worked example: Growth of potential output
Policies raise productivity growth to 2% a year, and hours worked grow 1% a year. About how fast does potential output grow?
- Potential output = output per hour × hours.
- Growth $\approx 2\% + 1\% = 3\%$ a year: LRAS shifts right about 3% each year.
Answer: About 3%
Common mistake
Thinking any boost to demand raises long-run growth. Spending that only shifts AD does not raise potential output unless it adds to the economy's capacity to produce. Check: after the spending is over, does the economy have more capital, skills or ideas?