Actual versus Potential Growth

Idea

Actual and potential growth are shown in two distinct ways. Actual growth is a rise in current output; potential growth is a rise in productive capacity — the maximum the economy could produce. Both can be drawn on the production possibility curve and on an aggregate demand–aggregate supply (AD–AS) diagram, and the two representations agree.

Mechanism

Actual growth — output rises towards existing capacity. On the PPC it is a movement from a point inside the curve towards it; on an AD–AS diagram it is a rightward shift of aggregate demand (AD), raising real national output as spare capacity is taken up. This is the same actual-growth move already set out for the PPC.
Potential growth — capacity itself rises, driven by an increase in the quantity or quality of the factors of production. On the PPC it is an outward shift of the whole frontier; on an AD–AS diagram it is a rightward shift of long-run aggregate supply (LRAS).

For an economy to grow steadily, both must move together: potential growth raises the ceiling, actual growth lifts output to it.

Diagram

Actual growth: aggregate demand shifts right from AD₀ to AD₁ along the horizontal (spare-capacity) range of LRAS, raising real national output from Y₀ to Y₁ with the general price level unchanged at P.

Potential growth: long-run aggregate supply shifts right from LRAS₀ to LRAS₁ as the quantity or quality of resources rises, expanding productive capacity; with AD₁ unchanged, real national output rises from Y₀ to Y₁.

Considerations

The pace of the two matters as much as their direction. If actual growth outruns potential growth, the economy approaches full employment with demand still rising, and the extra demand spills into demand-pull inflation rather than output — the economy overheats. If potential growth outruns actual growth, capacity is built faster than demand uses it, leaving excess capacity and a widening output gap that shows up as demand-deficient unemployment. The two-way mapping onto AD and LRAS is what lets a policy be classified: investment, education and immigration build capacity (potential growth); measures that raise spending on existing capacity drive actual growth.