AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/5/5-7)
Unit 5 · Topic 5.7
5.7 Public Policy and Economic Growth
Governments try to raise long-run growth with policies that make workers more productive or bring more people into the workforce, such as education, infrastructure and support for research. Supply-side fiscal policies change taxes and other incentives to encourage working, saving and investing. The models predict which way these policies push the economy; economists disagree about how big the effects are.
Key terms
- supply-side fiscal policy
- infrastructure
- human capital investment
- research and development
- labor force participation
- potential output
Policies that raise productivity
Each of these raises potential output, shifting LRAS right and the PPC outward. They take time, though: a new highway or a generation of better-trained workers can take years to pay off.
- Education and job training build human capital: workers who know more produce more per hour.
- Infrastructure, such as roads, ports, broadband and power grids, is physical capital that helps many businesses move goods and information more cheaply.
- Funding for research and development (R&D), along with patents that protect new inventions, encourages new technology, which improves how inputs are combined.
- Public health programs raise human capital by keeping workers healthy and on the job.
Policies that raise labor force participation
Real GDP per capita also rises if a larger share of people work. Policies aimed at labor force participation include help with child care, programs that connect people with jobs, and tax or benefit rules that change how much a person gains from working. When more of the population works, output per person can rise even if output per worker stays the same.
Supply-side fiscal policy
Supply-side fiscal policies use taxes, spending and regulation to change people's incentives to work, save, invest and start businesses. Examples include lower income tax rates, tax credits for business investment and lower taxes on the returns to saving. These policies can affect both sides of the AD–AS model:
- Demand side, in the short run: a tax cut raises disposable income or business spending, so AD shifts right.
- Supply side, in the short and long run: if people work more and firms invest more in capital, SRAS and LRAS shift right and potential output rises.
Putting it on the graph
When a policy raises both AD and LRAS, potential output rises, so long-run real GDP is higher. The effect on the price level depends on which shift is larger.
When a change raises only aggregate supply, such as a technology breakthrough, the model predicts higher real GDP and a lower price level than there would have been otherwise.
How big the supply-side effects are is debated. Some economists find large effects on work and investment, while others find small ones and point out that tax cuts can widen deficits, which may crowd out private investment (5.5). Exam questions ask which direction the model predicts, not whether a policy is a good idea.
Worked examples
Try each one yourself first, then open the solution.
- Example 1
An investment tax credit, short run and long run
The government introduces an investment tax credit for businesses. Explain its effect on (a) the loanable funds market, (b) AD in the short run, and (c) LRAS and economic growth in the long run.
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- Step 1: (a) Investment projects become more profitable, so firms want to borrow more: DLF shifts right, and the real interest rate and quantity of loanable funds both rise.
- Step 2: (b) Business investment spending rises, so AD shifts right.
- Step 3: (c) More investment adds to the stock of physical capital. With more capital per worker, productivity rises, so LRAS shifts right and the economy grows faster.
Answer: (a) DLF shifts right; the real interest rate rises. (b) AD increases. (c) The capital stock grows, so LRAS shifts right and growth increases.
- Example 2
Choosing growth policies
A country wants to raise its long-run growth rate. Give one policy that would increase human capital and one that would increase physical capital, and explain how each affects LRAS.
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- Step 1: Human capital: fund job training or expand access to education. Workers gain skills and produce more per hour, so productivity rises.
- Step 2: Physical capital: build infrastructure such as roads or broadband, or give firms a tax credit for new equipment. Workers have more and better tools, so productivity rises.
- Step 3: Higher productivity raises the economy's potential output, so LRAS shifts right in both cases.
Answer: For example, job training (human capital) and infrastructure spending (physical capital); both raise productivity and shift LRAS right.
- Example 3
Demand policy or growth policy? (classic trap)
A student says a temporary increase in unemployment benefits will raise long-run economic growth because it increases spending. Evaluate the claim.
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- Step 1: Unemployment benefits are transfer payments. Higher transfers raise disposable income and consumption, so AD shifts right in the short run.
- Step 2: Long-run growth requires more physical capital, more human capital, better technology or more labor. A temporary rise in benefits doesn't directly add to any of these.
- Step 3: So the policy is a short-run demand policy. It can raise real GDP toward full employment in a recession, but it doesn't shift LRAS.
Answer: The claim mixes up demand and supply: the policy shifts AD in the short run but doesn't directly raise long-run growth.
Common mistakes
- Treating any increase in spending as a growth policy. A policy raises long-run growth only if it adds to physical capital, human capital, technology or labor force participation.
- Saying supply-side tax cuts affect only aggregate supply. They usually shift AD too, at least in the short run.
- Giving a policy opinion instead of a prediction. Write what the model predicts (for example, LRAS shifts right), not whether the policy is good.
On the exam
- Free-response questions may ask you to name a policy that increases long-run growth and explain how. Name the policy, the input it raises (for example, human capital) and the result (LRAS shifts right).
- Expect questions that pair a short-run policy with its long-run effect, such as a deficit that crowds out investment and slows growth.
Connected topics
Videos
Check yourself
4 questions on 5.7 Public Policy and Economic Growth. Pick an answer to see if you got it, and why.
A government builds new highways and broadband networks that lower firms' transportation and communication costs. According to the AD–AS model, what is the most likely long-run effect?
A government cuts marginal income tax rates with the stated goal of encouraging people to work, save and invest more. If the policy works as intended, what does the AD–AS model predict in the long run?
A tax cut meant to boost long-run growth also raises households' disposable income. Which of the following best describes its effects in the AD–AS model?
Which of the following government policies most directly increases an economy's human capital?
0 of 4 answered