Some policies only push aggregate demand. Others build the economy's capacity to produce, which is what long-run growth means. Turn policies on and off, then flip between the short run and the long run to see which effect lasts.
The economy starts in long-run equilibrium at full employment. Dashed grey lines show the starting curves. Solid lines show the curves after the policies you pick.
Long-run economic growth is an increase in potential output. On the graphs, LRAS shifts right and the production possibilities curve shifts outward. Pushing AD past potential is not growth.
Spending on schools, job training, and health makes each worker more productive. It raises AD a little now and shifts LRAS right later.
Roads, ports, broadband, and private machinery let workers produce more. An investment tax credit encourages firms to buy capital, which adds to AD now and to capacity later.
Subsidies for research and patent protection reward new ideas. Better technology raises productivity, so the same inputs make more output.
Supply-side economists argue that lower marginal tax rates and lighter regulation increase incentives to work, save, and invest, shifting aggregate supply right. Economists disagree about how large these effects are.
The Laffer curve shows that revenue is zero at a 0% tax rate and also at a 100% rate, so it peaks somewhere in between. If rates are above the peak, a cut could raise revenue. Economists disagree about where the economy sits on the curve.
When the government borrows, it raises the real interest rate in the loanable funds market. Private investment falls, the capital stock grows more slowly, and long-run growth is lower than it would have been.
Growth comes from more and better capital, more skilled labor, and better technology. Policy helps growth when it adds to one of these, not when it only adds spending.
Expansionary monetary policy and spending at full employment raise output only for a while. In the long run the economy returns to potential, and the only lasting effect is a higher price level.
Ask two questions about any policy: does it shift AD now, and does it add to the economy's productive capacity later?
| Policy | Short run | Long run growth |
|---|---|---|
| Spending on education and job training | AD shifts right (government spending) | LRAS shifts right: more human capital |
| Infrastructure spending | AD shifts right | LRAS shifts right: more public capital |
| R&D subsidies, patent protection | Small AD effect | LRAS shifts right: better technology |
| Investment tax credit | AD shifts right (investment rises) | LRAS shifts right: more physical capital |
| Lower marginal tax rates (supply side) | AD shifts right and SRAS may shift right | LRAS shifts right if incentives to work, save, and invest rise |
| Reducing costly regulation | SRAS shifts right | LRAS shifts right: lower production costs |
| Deficit-financed spending at full employment | AD shifts right, real interest rate rises | Crowding out lowers investment, so growth is slower than it would have been |
| Expansionary monetary policy | AD shifts right | No change in LRAS; only the price level is higher |
AP-style multiple choice. Pick an answer to see the explanation.
The vocabulary for topic 5.7. Read the list, flip through flashcards, or quiz yourself. For every term in the unit, see the Unit 5 terminology guide.