Topic 5.7 Notes – Public Policy and Economic Growth

What Economic Growth Is and How Policy Affects It

Long-run economic growth is a sustained increase in real GDP per capita.
That means more output per person, not just more total output.

Graphically, growth shows up as increases in an economy’s productive capacity.

LRAS Shifting Right

In the AD-AS model, growth appears as a rightward shift of the long-run aggregate supply curve.

Rightward shift of LRAS (increase in potential output)

When LRAS shifts right, potential output increases from Yf to Yf1. The economy can produce more at every price level.

PPF Shifting Outward

You can see the same idea using a production possibilities frontier.

Outward shift of the production possibilities frontier

An outward shift of the PPF means the economy can produce more of all goods, like both farming and fishing in the graph.

Both visuals show the same idea: growth = greater productive capacity.

What Growth Depends On

Growth comes from improvements in:

• Labor (quantity and quality)
  More workers or more skilled workers.
• Human capital
  Education, job training, skills.
• Physical capital
  Tools, factories, machines.
• Technology
  Better ways to combine inputs.
• Natural resources

Public policy matters because it can increase productivity (output per worker) and labor force participation.

If a policy raises either of those → real GDP per capita rises → LRAS shifts right.

Government Policies That Promote Long-Run Growth

Think of four main channels.

1. Investment in Human Capital

When the government funds education or job training, workers become more productive.

Examples:

• Public education spending
• Workforce retraining programs
• The GI Bill after WWII, which expanded college access

More skilled workers → higher output per worker → LRAS shifts right → real wages rise over time.

2. Investment in Physical Capital and Infrastructure

Infrastructure includes roads, bridges, ports, power grids, broadband.

Examples:

• The U.S. Interstate Highway System
• Modern infrastructure bills expanding transportation and internet access

Infrastructure lowers production and transportation costs. That increases productivity across the entire economy. Result: LRAS shifts right.

In the short run, higher government spending can also shift AD right, but the growth effect comes from the productivity boost.

3. Policies That Encourage Technological Progress

Technology drives long-run growth.

Government can:

• Fund research and development (R&D)
• Protect intellectual property rights (patents)
• Support entrepreneurship

Historical anchors:

• Federal R&D during and after WWII
• Government-backed research that helped create the internet and GPS

New technology increases total factor productivity. Same inputs, more output. That’s pure LRAS growth.

4. Policies That Increase Labor Force Participation

Growth also happens when more people work.

Policies include:

• Lower income taxes
• Childcare support
• Immigration reform
• Welfare reform that encourages employment

More workers → more total output → higher potential GDP → LRAS shifts right.

Supply-Side Fiscal Policy

Supply-side fiscal policies are government actions designed to increase output by shifting SRAS and LRAS right, mainly by changing incentives.

Common tools:

• Lower marginal income tax rates
• Lower corporate taxes
• Reduced regulation
• Investment tax credits (tax reductions for firms that invest)

This approach became prominent in the 1980s under President Reagan.

Contrast it with demand-side fiscal policy, which focuses on shifting AD through government spending or tax changes aimed at boosting demand.

Supply-side focuses on production incentives.

How Supply-Side Policies Work in the Short Run and Long Run

Short Run

In the short run, supply-side tax cuts affect both demand and supply.

When taxes are cut:

• Households have more disposable income → AD shifts right
• Firms face lower costs → SRAS shifts right

In the diagram, AD shifts from AD₁ to AD₂, and SRAS also shifts right. Real GDP rises from Y_e to Y₂. The price level increases, but the rise is smaller than it would be if only AD had shifted.

Output rises. Price level pressure is smaller than with pure demand-side policy.

Long Run Incentive Chain

Supply-side economists argue:

1. Lower taxes → higher after-tax income
2. More saving
3. Greater supply of loanable funds
4. Lower real interest rates
5. More investment
6. Capital accumulation
7. LRAS shifts right

Over time, this increase in capital and productive capacity shifts the vertical LRAS curve to the right, expanding the economy’s full-employment output.

They also emphasize:

• Productivity incentive: Workers keep more income, so they work more.
• Risk-taking incentive: Higher after-tax profits encourage entrepreneurship.

This connects to the debate over “trickle-down economics” and whether tax cuts “pay for themselves.” The Laffer Curve suggests tax revenue may rise if very high tax rates are cut, but that outcome is not guaranteed.