The earlier lessons used fiscal and monetary policy to shift aggregate demand and manage the short-run cycle. But rising living standards over decades come from the supply side — from the economy's capacity to produce growing. Long-run economic growth is an outward expansion of that capacity, shown as a rightward shift of the long-run aggregate supply (LRAS) curve, and its main engine is labour productivity.
Why long-run growth matters
Demand-side policy can lift output back toward capacity, but it cannot raise capacity itself. Sustained improvements in real incomes, employment opportunities and the government's ability to fund services all depend on the productive capacity of the economy growing faster than the population — and that depends on productivity.
Labour productivity
Labour productivity is output per unit of labour input (e.g. real GDP per hour worked). When each worker produces more, the same labour force can generate more output, real wages can rise sustainably, and unit costs fall. The relationship between inputs and output is captured by the aggregate production function (APF), which shows how the quantity and quality of labour and capital, combined with technology, determine total output.
What drives productivity growth
- Human capital — the skills, education, training and health of the workforce. Better-skilled workers produce more per hour.
- Capital deepening — more (and better) physical capital per worker, so each worker has more and superior tools and equipment.
- Technological progress — innovation and better ways of organising production, which raise output from the same inputs and is the most important driver of long-run growth.
Showing it on the AD/AS model
A rise in productivity increases the economy's potential output, shifting the vertical LRAS curve to the right. With AD unchanged, the result is higher real output and downward pressure on the price level — growth without inflation, the ideal long-run outcome.
Government policies to raise productivity
Because productivity drives long-run living standards, governments pursue microeconomic (supply-side) reform: investment in education and training (human capital); infrastructure and incentives for business investment (capital deepening); support for research, development and innovation (technology); and competition and labour-market reforms that improve the efficient use of resources.
Separate "more inputs" from "more output per input", and connect drivers to the LRAS shift together.
Classify the driver
For each, name the productivity driver (human capital / capital deepening / technological progress) and a matching government policy: (a) a national apprenticeship and TAFE expansion; (b) a tax incentive for firms investing in new machinery; (c) public funding for research grants and innovation hubs.
1. Define labour productivity and give one way it could be measured.
2. Explain why long-run economic growth is important and why demand-side policy alone cannot deliver it.
3. Identify and explain three factors that affect labour productivity growth.
4. Using the AD/AS model, illustrate and explain the effect of an increase in labour productivity on real output and the price level.
5. Outline two government policies that aim to raise productivity, linking each to the driver it targets.
6. Distinguish between an increase in aggregate demand and an increase in productive capacity, referring to which curve shifts in each case.