Factors Affecting Economic Growth

by Tejvan Pettinger on February 22, 2011 in economics

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

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 remortgage 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

1. 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.
2. 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.
3. 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 growth.
Weather. The exceptionally cold December in UK 2010, led to a shock fall in GDP
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