This revision note looks at trend or long term growth in an economy. The trend rate of growth is the long run average rate for a country over a period of time. Measuring the trend requires a long-run series of data to identify the different stages of the economic cycle and then calculate average growth rates from peak to peak or trough to trough.
Another way of thinking about the trend growth rate is to view it as a safe speed limit for the economy. In other words, an estimate of how fast the economy can reasonably be expected to grow over a number of years without creating an increase in inflationary pressure.
Above trend growth – positive output gap: If the economy grows too quickly (much faster than the trend) – then aggregate demand will eventually exceed long-run aggregate supply and lead to a positive output gap emerging (excess demand in the economy). This can lead to demand-pull and cost-push inflation.
Below trend growth – negative output gap: If the economy experiences a sustained slowdown or recession (i.e. growth is well below the trend rate) then output will fall short of potential GDP leading to a negative output gap. The result is downward pressure on prices and rising unemployment because of a lack of aggregate demand.
For the UK, the trend rate of growth is estimated to be close to 2.5% per year although the OECD and some other economic forecasters have recently downgraded this to below 2% a year. Obviously it is much higher for many emerging market countries that are enjoying rapid growth and major economic change. China’s trend growth rate is probably closer to 8 or 9% per year whilst for India the long run average growth rate is well above 6% a year.
Potential output depends on the following factors
(1) The growth of the labour force—those people able available and willing to find employment: The Government has invested heavily in a number of schemes designed to raise employment including New Deal and reforms to the tax and benefit system. Changes in the age structure of the population also affect the total number of people seeking work. And we must also consider the effects that migration of workers into the UK from overseas, including the newly enlarged European Union, can have on our total labour supply. The age structure of the population also affects the size of the labour force.
(2) The growth of the nation’s stock of capital – driven by the level of fixed capital investment. This is often seen as the most important method of increasing growth - especially investment in critical infrastructure
(3) The trend growth of productivity of labour and capital. For most countries it is what happens to productivity that drives the long-term growth. The causes of improved efficiency come from making markets more competitive and achieving increased output per work within individual plants and factories.
(4) Technological improvements that flow from innovation are important because they reduce the costs of supplying goods and services which leads to an outward shift in a country’s production possibility frontier
To understand better the means by which an economy’s productive capacity and competitiveness can be improved - make sure you revise thoroughly supply-side policies.