Economic Growth, Unemployment and Inflation: Question 5

Worked solution

Part (a): One demand-side cause and one supply-side cause of growth

Demand-side channel (increased public investment in transport infrastructure. Government spending (G) is a component of aggregate demand (AD $= C + I + G + (X-M)$). When the government spends more on infrastructure, aggregate demand shifts to the right. If Meridia’s economy has spare capacity (unemployed resources) at the time, firms can respond to this higher demand by producing more, so real output and real GDP rise) this is growth caused by a rightward shift of AD along an unchanged, or only slowly changing, aggregate supply curve. The construction workers and suppliers involved in the infrastructure projects also earn additional income, some of which they go on to spend elsewhere in the economy, adding to the initial rise in aggregate demand.

Supply-side channel, expanded technical-training programmes. Training school leavers in technical skills improves the quality of Meridia’s future labour force, an increase in human capital. This raises the productivity of workers and the economy’s ability to produce output using its existing quantity of resources, which increases the economy’s productive capacity. Diagrammatically, this is shown as a rightward shift of the long-run aggregate supply (LRAS) curve (or an outward shift of the production possibility curve): the economy can now sustainably produce more real output than before, at any given price level, which is growth caused by a shift in aggregate supply rather than aggregate demand.

(The tax incentives for machinery investment work through a similar supply-side channel, by raising the economy’s capital stock, and would also be a valid supply-side answer alongside training.)

Part (b): Discussing the extent to which citizens benefit

The case that citizens benefit. Sustained real GDP growth generally raises average real income per person, so citizens can typically afford more goods and services and enjoy a higher material standard of living. Growth driven partly by rising investment and improved skills, as in Meridia, tends to create more and often better-paid jobs, which also lowers unemployment and the personal and social costs that go with it. Higher output and incomes also increase the government’s tax revenue without needing to raise tax rates, giving it more resources to fund public services such as healthcare, education and infrastructure. Services that can raise living standards still further, including for people not directly employed in the growing sectors.

Reasons the benefit may be limited or uneven. However, growth does not automatically benefit every citizen equally. The gains from growth can be distributed very unevenly. For example, if the benefits flow mainly to owners of capital and highly skilled workers in the growing sectors, while wages for other workers rise more slowly, income inequality could widen even as average income rises. Growth can also carry costs that reduce citizens’ wellbeing even as measured income rises: more production and infrastructure activity can increase pollution, congestion and pressure on natural resources, particularly if environmental impacts are not addressed alongside the training and investment measures described. There is also a risk that if aggregate demand (boosted by the infrastructure spending) grows faster than the economy’s underlying productive capacity, the result could be demand-pull inflation, which would erode the real value of any nominal income gains for citizens.

Reaching a judgement. Because Meridia’s growth in this scenario is driven partly by genuine supply-side improvements (more capital from machinery investment and better skills from training, not by demand expansion alone) it is more likely to be sustainable and to raise the economy’s underlying capacity to produce, rather than simply pushing prices up once spare capacity is used up. This makes it more likely, on balance, to deliver a lasting benefit to citizens than growth driven purely by a demand-side boost. Even so, the extent of the benefit for any individual citizen still depends on how evenly the gains from growth are shared across the population and on whether any environmental or congestion costs of the extra infrastructure and production are managed, so the benefit, while real, should not be assumed to be automatic or equally shared.

Final answers

• (a) Demand-side: higher public investment (G) raises aggregate demand directly. Supply-side: expanded technical training raises human capital and shifts LRAS/the PPC outward, raising productive capacity.
• (b) Growth is likely to raise average incomes, employment and government revenue for public services, but the extent of the benefit to citizens depends on how evenly the gains are shared and on managing any environmental, congestion or inflation costs, so the benefit is real but conditional, not automatic or universal.