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Factors Affecting Economic Growth

Economic growth is an increase in real GDP. It means an increase in the value of

goods and services produced in an economy. The rate of economic growth
measures the annual percentage increase in real GDP. There are several factors
affecting economic growth, but it is helpful to split them up into:

Demand side factors

Supply side factors

Let us look at the economic growth of the United Kingdom (UK) as

our example:
Recent Economic Growth in UK

Demand Side Factors Influence Growth of Aggregate

Demand (AD)
AD= C+I+G+X-M. Therefore a rise in Consumption, Investment, Government
spending or exports can lead to higher AD and higher economic growth.

Graph Showing Rise in AD

What Could Affect AD?

Interest Rates. Lower interest rates would make borrowing cheaper and
should encourage firms to invest and consumers to spend. People with mortgages
will have lower monthly mortgage payments so more disposable income to spend.
However, recently we had a period of zero interest rates, but due to low confidence
and reluctant banks growth was still sluggish.

Consumer Confidence. Consumer and business confidence is very

important for determining economic growth. If consumers are confident about the
future they will be encouraged to borrow and spend. If they are pessimistic they will
save and reduce spending.

Asset Prices. Rising house prices create a positive wealth effect. People can
reportage against the rising value of their home and this encourages more consumer
spending. House prices are an important factor in the UK, because so many people
are homeowners.

Real Wages. Recently, the UK has experienced a situation of falling real

wages. Inflation has been higher than nominal wage, causing a decline in real
incomes. In this situation, consumers will have to cut back on spending reducing
their purchase of luxury items.

Value of Exchange Rate. If the Pound devalued, exports would become more
competitive and imports more expensive. This would help to increase demand for
domestic goods and services. A depreciation could cause inflation, but in the short
term at least it can provide a boost to growth.

Banking Sector. The 2008 Credit crunch showed how influential the banking
sector can be in determining investment and growth. If the banks lose money and no
longer want to lend, it can make it very difficult for firms and consumers leading to a
decline in investment.

Factors that determine Long Run Economic Growth

In the long run, economic growth is determined by factors which influence the growth
of Long Run Aggregate Supply (the PPF of the economy). If there is no increase in
LRAS, then a rise in AD will just be inflationary.

This graph shows an increase in LRAS and AD, leading to an increase in economic
growth without inflation.

LRAS can be influenced by


Levels of infrastructure. Investment in roads, transport and communication

can help firms reduce costs and expand production. Without necessary infrastructure
it can be difficult for firms to be competitive in the international markets. This lack of
infrastructure is often a factor holding back some developing economies.


Human Capital. Human capital is the productivity of workers. This will be

determined by levels of education, training and motivation. Increased labour
productivity can help firms take on more sophisticated production processes and
become more efficient.


Development of Technology. In the long run development of new technology

is a key factor in enabling improved productivity and higher economic growth.

Other Factors that Can Affect Growth in the Short Term.

Commodity Prices. A rise in commodity prices such as a rise in oil prices

can cause a shock to growth. It causes SRAS to shift to the left leading to higher
inflation and lower growth.

Political Instability. Political instability can provide a negative shock to

Weather. The exceptionally cold December in UK 2010, led to a shock fall in


Annual Rate of Economic Growth in UK

Examples of Economic Growth

A graph showing Quarterly economic growth in UK.

In 1981 and 1991, there are two periods of negative economic growth. In 1981, this
negative economic growth was due to:

Higher interest rates (reducing borrowing)

Lower government spending (tight fiscal policy)

Appreciation in the value of the pound which made exports uncompetitive.

In the mid-1980s, the high economic growth was caused by

Rising consumer confidence

Relatively low real interest rates

Rising wages

Rising house prices causing a rise in wealth and consumer spending

Graph Showing Annual Growth in UK

In 2009, the sharp fall in Real GDP (negative economic growth) was caused by:

Higher oil prices reducing living standards

Global credit crunch leading to a fall in bank lending and investment

Fall in house prices causing lower wealth and spending