Actual and potential growth, the trade cycle and the output gap on an AD/AS diagram: a negative gap with spare capacity, a positive gap at overheating, and the LRAS shift that is long-run growth. The benefits and costs of growth, through the UK’s slow years since 2023.
UK real GDP grew 0.4% in 2023, 1.1% in 2024 and 1.2% in 2025. In the last two quarters of 2023 it fell, by 0.2% and then 0.3%: two quarters of falling output, which is the usual definition of a recession. Between 1993 and 2007 the economy had grown by about 3% a year.
The chart shows the rate of growth each year since 1990. The economy is bigger than it was, but the question for policy is not only how fast it is growing. It is how far it is from what it could produce.
What is the difference between growing and growing to capacity?
Source: Office for National Statistics, quarterly national accounts, 29 September 2026 (series IHYP, annual growth; IHYQ, quarterly growth).
Economic growth is an increase in real GDP: the value of an economy’s output adjusted for inflation. It is measured as the percentage change in real GDP over a year or a quarter.
Actual growth is the measured rise in real GDP from one period to the next. Potential growth is the rise in the economy’s productive capacity: the most it could produce with all its resources fully and efficiently used, shown by LRAS or the PPF.
The output gap is the difference between actual real GDP and potential real GDP, usually given as a percentage of potential. A negative output gap means spare capacity and unemployment. A positive output gap means output above the sustainable level, with overtime, shortages and rising prices.
The trade cycle (or business cycle) is the pattern of actual growth around the trend: boom, slowdown, recession and recovery. A recession is two consecutive quarters of falling real GDP. Assumptions: potential output cannot be observed directly, so it is estimated, and ceteris paribus applies to each shift.
The UK economy grows by 1% in a year.
Over the same year the number of workers and the capital stock grow enough to produce 2% more.
What has happened to the gap between what the economy produces and what it could produce?
Growth of 1% against capacity growing 2% means actual output fell further behind potential output. Economic growth and a widening output gap can happen in the same year. That is what the output gap measures: actual against potential.
Draw it in exam order: axes, LRAS at full employment output Yfe, then SRAS, then AD1. The economy settles where AD1 meets SRAS, at P1 and Y1. Y1 is to the left of Yfe: the economy is producing less than it could.
Check: An economy’s real GDP is £2.4 trillion. Its potential output is estimated at £2.5 trillion. The output gap is:
Gap = (actual − potential) ÷ potential × 100 = (2.4 − 2.5) ÷ 2.5 × 100 = −4%. Actual output is below potential, so the gap is negative.
The distance from Y1 to Yfe is the negative output gap: spare capacity. Workers are unemployed, factories and shops are quiet. Growth that closes this gap is actual growth: using resources the economy already has. In 2009 and again in 2020 the UK’s gap was deeply negative.
Check: At Y1, which of these would you expect to see in the real economy?
Output below potential means some workers and machines are idle: unemployment is higher than normal and firms could produce more without raising prices much.
Now AD rises to AD2: a boom in confidence, a tax cut, cheap credit. The economy moves to P2 and Y2, to the right of Yfe. The distance from Yfe to Y2 is a positive output gap. Output is above its sustainable level: overtime, shortages, workers poached with higher pay, demand-pull inflation.
Teacher tip: A positive gap cannot last. Wages and costs rise, SRAS shifts left, and output falls back towards Yfe at a higher price level.
Check: AD is about to rise to AD2, past Yfe. Predict first: what happens to the price level compared with the rise in output?
Past Yfe firms are bidding for scarce workers and materials, so costs and prices rise fast for a small gain in output.
Potential growth is different. If the quantity or quality of the factors of production improves, capacity rises and LRAS shifts right, to LRAS2. The causes: investment in capital, productivity gains from technology and skills, more labour through migration or participation, and innovation. This is the PPF shifting outwards. It is the only growth that lasts without inflation.
Check: Which of these raises potential growth rather than actual growth?
More and better capital raises what the economy can produce: LRAS shifts right. The other three raise AD, which closes a gap but does not move capacity.
Put the two together and you have the UK’s problem since 2008. Productivity growth slowed from about 2% a year to about 0.5%, so LRAS has moved right slowly. Actual output has grown slowly too. Growth of about 1% a year keeps pace with a slow-moving LRAS but never closes the gap or raises living standards much.
Check: The UK grew 1.2% in 2025. If potential output also grew by about 1.2%, what happened to the output gap?
When actual and potential output grow at the same rate, the gap between them does not change. Growth alone does not tell you whether the gap is closing.
Why growth matters. Higher living standards: more goods and services per person. Jobs: firms hire to produce more. Tax revenue: the government raises more at the same rates and can spend more on health and education, or borrow less. Investment: profitable firms invest, which raises potential growth in turn.
Check: Which is a benefit of economic growth that comes through the government’s budget?
As incomes, spending and profits rise, income tax, VAT and corporation tax all raise more at the same rates, and spending on unemployment benefits falls.
And the costs. Inflation when growth runs ahead of capacity. Current account: richer households buy more imports. Inequality: the gains may go to owners of capital and the already skilled. Environment: more output means more energy, resources and emissions unless growth comes from cleaner technology. Short-termism: growth by consumer borrowing can leave debts behind.
Check: Which cost of growth is most likely when growth comes from a positive output gap?
Growth that pushes output beyond Yfe means firms competing for scarce resources, which pulls up prices.
Y1 is to the left of Yfe: output is below potential, so the gap is negative, not positive. A positive gap is output above Yfe, to the right of LRAS.
Using an AD/AS diagram, explain the difference between actual and potential economic growth.
Economic growth is an increase in real GDP, the value of output adjusted for inflation. Potential output is the most the economy can produce with its resources fully and efficiently used, shown by the vertical LRAS curve at Yfe.
[Diagram: price level against real GDP. LRAS vertical at Yfe. SRAS sloping up. AD1 crossing SRAS at Y1, to the left of Yfe, with the negative output gap marked. LRAS2 to the right of LRAS, labelled potential growth.]
Actual growth is the measured rise in real GDP from year to year. When there is a negative output gap, as at Y1, a rise in aggregate demand, from a tax cut or lower interest rates for example, moves the economy along SRAS towards Yfe. Output rises because idle workers and machines are put to work, so this growth comes with little inflation.
This kind of growth has a limit. Once output reaches Yfe there is no spare capacity, and a further rise in AD creates a positive output gap: firms compete for scarce workers and materials and the price level rises faster than output.
Potential growth is a rise in capacity itself: LRAS shifts right from Yfe to Yfe2 because the quantity or quality of the factors of production has improved, through investment in capital, higher productivity, a larger labour force or new technology. This is the same as the PPF shifting outwards.
**However,** the two are linked: actual growth that encourages firms to invest can raise potential growth, and a long negative gap can lower potential as workers lose skills and firms shut capacity. The UK since 2008 shows the cost of slow potential growth: productivity rising at about 0.5% a year instead of 2% has held actual growth at around 1% whatever happens to demand.
GDP figures: Office for National Statistics, quarterly national accounts (series IHYP and IHYQ), released 29 September 2026. The price level and output figures in the diagram are invented to make the gaps clear. Diagrams drawn with Rough.js and perfect-freehand, both MIT licensed.