Economic Growth

CFA Level 2 | Economics | Learning Module 2

Growth In The Global Economy

Forecasts of long-run economic growth are important for global investors because equity prices reflect expectations of future earnings, which depend on future economic activity.
In the long term, the same factors that drive economic growth will be reflected in equity values.
The expected long-run growth rate of real income is a key determinant of the average real interest rate level.
In the shorter term, the relationship between actual and potential growth is a key driver of fixed-income returns.
Investors need to identify and forecast the factors that drive long-term sustainable growth trends to develop global portfolio strategies and investment return expectations.
The study of economic growth focuses on the long-run trend in aggregate output as measured by potential GDP, in contrast to the short-run fluctuations of the business cycle.
Over long periods, the actual growth rate of GDP should equal the rate of increase in potential GDP because output in excess of potential GDP is unsustainable.
The growth rate of potential GDP acts as an upper limit to growth and determines the economy’s sustainable rate of growth.
Increasing the growth rate of potential GDP is key to raising income, profits, and the living standard.
Economic growth is calculated as the annual percentage change in real GDP or in real per capita GDP.
Real per capita GDP reflects the average standard of living.
Growth in real GDP per capita implies a rising standard of living.
Cross-country comparisons of GDP should be based on purchasing power parity (PPP) rather than current market exchange rates to account for differences in the prices of non-traded goods and services.
Developed economies tend to be those with high per capita GDP, but there are no universally agreed-upon criteria for classification.
Developed and developing countries differ with respect to the presence or absence of appropriate institutions that support growth.
The literature on economic growth primarily focuses on the role of capital and labor resources and the use of technology as sources of growth.

Factors Favoring And Limiting Economic Growth

A major problem for some developing countries is a low level of capital per worker.
Countries accumulate capital through private and public sector investment.
Increasing the investment rate may be difficult in developing countries due to low levels of disposable income.
Growth depends on how efficiently saving is allocated within the economy.
The financial sector channels funds from savers to investment projects.
Financial markets and intermediaries can promote growth by screening and monitoring borrowers, encouraging savings and risk-taking, and mitigating credit constraints.
Free trade generally benefits an economy by providing more goods at lower costs and increasing competition.
Factors limiting growth in developing countries include low rates of saving and investment, poorly developed financial markets, weak legal systems, lack of property rights, political instability, poor public education and health services, discouraging tax and regulatory policies, and restrictions on international trade and capital flows.
Lack of physical, human, and public capital, as well as little or no innovation, can also limit growth in developing countries.
Sustained differences in GDP growth rates over decades significantly alter the relative incomes of countries.
Preconditions for economic growth include well-functioning financial markets, clearly defined property rights and rule of law, open international trade and capital flows, an educated and healthy population, and encouraging tax and regulatory policies.

Why Potential Growth Matters To Investors

The long-run rate of stock market appreciation is related to the sustainable growth rate of the economy.
Equity prices reflect expectations of the future stream of earnings, which depend on expectations of future economic activity.
Potential GDP and its growth rate matter for equity and fixed income investors.
Expected equity return can be decomposed into dividend yield, expected repricing, inflation rate, real economic growth, and change in shares outstanding.
Changes in P/E ratios (repricing) may trend higher with increasing GDP growth as investors perceive less risk.
Dilution effects, such as net buybacks and relative dynamism (issuance of new shares or reduction in outstanding shares due to factors like privatization or delistings), can cause divergence between real economic growth and equity returns.
Simply extrapolating past GDP growth can produce incorrect forecasts because a country’s growth rate can change over time.
Changes in economic factors and policies that affect potential growth have a large compounded impact on living standards and economic activity, which in turn affects long-run stock market returns.
Potential GDP forecasts can gauge inflationary pressures arising from cyclical variations in actual output growth relative to long-term potential growth.
Actual GDP growth above (below) potential GDP growth puts upward (downward) pressure on inflation, affecting nominal interest rates and bond prices.
A higher rate of potential GDP growth improves the general credit quality of fixed-income securities.
Monetary policy decisions are affected by the output gap and the growth of actual GDP relative to potential GDP.
Government budget deficits are often judged relative to structural or cyclically adjusted deficits, which assume the economy is operating at potential GDP.
Long-term real GDP growth rates tend to be far less volatile than equity returns, especially for developed economies.
For countries with prudent monetary policies, inflation rates are also less volatile than stock prices.
Forecasts of long-term real and nominal GDP growth may be more reliable than equity market return forecasts based solely on historical equity returns.
When actual GDP growth is forecasted to be well below potential GDP growth, it suggests a growing output gap, potentially leading to downward pressure on inflation and lower short-term interest rates, which can cause bond prices to rise.

Production Function and Growth Accounting

Long-run economic growth is driven by labor, physical and human capital, technology, natural resources, and public infrastructure.
The Cobb-Douglas production function is a simple model representing the relationship between output and inputs: Y = AK^α L^(1-α).
MPK (marginal product of capital) = αY/K, and α represents capital’s share of GDP.
1 − α represents labor’s share of income.
The growth accounting equation decomposes output growth into components attributable to technology, capital, and labor: ΔY/Y = ΔA/A + αΔK/K + (1 − α)ΔL/L.
α is the elasticity of output with respect to capital, and (1 − α) is the elasticity of output with respect to labor.
The growth accounting equation can be used to estimate potential output using trend estimates of labor and capital.
Total factor productivity (TFP) growth (ΔA/A) is often estimated as a residual.
An alternative method of measuring potential GDP is the labor productivity growth accounting equation: Growth rate of potential GDP = Long-term growth rate of labor force + Long-term growth rate in labor productivity.
An expanded production function includes raw materials (N), labor quantity (L), human capital (H), ICT capital (KIT), non-ICT capital (KNT), public capital (KP), and technological knowledge (A): Y = AF(N,L,H,KIT,KNT,KP).

Capital Deepening vs. Technological Progress

Adding more and more capital to a fixed number of workers increases per capita output at a decreasing rate due to diminishing marginal returns.
Growth in per capita output comes from capital deepening (increase in capital-to-labor ratio) and technological progress (improvement in technology/TFP).
Capital deepening is a movement along the per worker production function.
Technological progress shifts the per worker production function upward.
Once the marginal product of capital equals its marginal cost, profit-maximizing producers will stop increasing the capital-to-labor ratio.
In the neoclassical model, once the steady state is reached, capital deepening cannot be a source of sustained per capita growth.
More rapid capital accumulation may lead to permanently higher per capita growth if the investment embodies new, innovative products and processes (endogenous growth).
Developing countries with low levels of capital per worker experience a larger impact on growth from increased investment compared to developed countries with high capital-to-labor ratios due to diminishing returns.
The simple correlation between the share of natural resources (e.g., oil reserves) and subsequent per capita GDP growth may not be statistically significant.

Labor Supply

Economic growth is affected by increases in labor and capital inputs.
Growth in the number of people available for work is an important source of economic growth.
The potential size of the labor input equals the labor force times the average hours worked per worker.
The labor force includes the working-age population (16-64) that is employed or unemployed.
Growth in the labor input depends on population growth, labor force participation, net migration, and average hours worked.
Demographic factors, such as the age distribution of the population, can have a significant impact on relative growth rates across countries.
Countries with a higher percentage of young people entering the workforce may experience a demographic benefit to growth.
Aging populations and lack of population growth can limit potential growth rates.
Net migration can significantly impact the growth rate of the labor force.
Average hours worked per year vary significantly across countries and have been declining in many developed countries.
Increased female labor force participation may contribute to shorter average workweeks due to more part-time employment.

ICT, Non-ICT, and Technology and Public Infrastructure

The physical capital stock increases with positive net investment.
Countries with higher investment rates should have a growing physical capital stock and higher GDP growth rates, although the impact on per capita GDP growth will be smaller with population growth.
Long-term sustainable growth cannot rely on pure capital deepening due to diminishing marginal productivity.
Investment-driven growth may last for a considerable period, especially in countries with low initial capital per worker.
A growing share of ICT investments may boost potential GDP growth through externality impacts.
Transformational technologies (General Purpose Technologies – GPTs) affect production and innovation across many sectors; ICT is a current example, and nanotechnology could be a future one.
The state of technology, reflected by TFP, embodies the cumulative effects of scientific advances, R&D, management improvements, and production organization.
Labor productivity growth depends on both capital deepening and technological progress (TFP growth).
The difference between labor productivity growth and TFP growth indicates the contribution of capital deepening.
Growth in per capita income cannot be sustained perpetually by capital deepening.
The level of labor productivity (GDP per hour worked) depends on the accumulated stock of human and physical capital and is generally higher in developed countries.
The growth rate of productivity may be higher in developing countries where capital is scarce but growing rapidly.
Long-term sustainable growth is determined by the rate of expansion of real potential GDP, driven by the expansion of production factors and improvements in technology.
The factors of production include human capital, ICT and non-ICT capital, public capital, labor, and natural resources.
Growth accounting can quantify the contribution of labor quantity, labor quality, non-ICT capital, ICT capital, and TFP to GDP growth.

Economic Growth Determinants

Long-term sustainable growth is determined by the expansion of real potential GDP.
Sources of growth include the expansion of factors of production (human capital, ICT and non-ICT capital, public capital, labor, natural resources) and improvements in technology.
Growth accounting framework helps evaluate the contribution of different sources to economic growth.

Theories of Growth

Three main paradigms explain per capita growth: classical, neoclassical, and endogenous growth models.
Classical Growth Theory (Malthusian Theory): Per capita growth is temporary and ends due to an exploding population with limited resources, leading to diminishing marginal returns to labor and a return to subsistence income.
Neoclassical Growth Theory (Solow Model): Long-run per capita growth depends solely on exogenous technological progress, with both capital and labor subject to diminishing marginal productivity.
The neoclassical model aims to determine the long-run growth rate of output per capita based on savings/investment rate, technological change, and population growth.
The steady-state rate of growth in the neoclassical model occurs when the output-to-capital ratio is constant, and capital per worker and output per worker grow at the same rate.
In the steady state, the growth rate of output per capita = θ / (1 − α), and the growth rate of output = θ / (1 − α) + n, where θ is the growth rate of TFP and n is the growth rate of labor.
In the steady state, the output-to-capital ratio is constant, and the marginal product of capital is also constant (equal to α(Y/K) and the real interest rate).
Higher saving rates in the neoclassical model lead to higher levels of capital per worker and output per worker but do not affect the long-run steady-state growth rate of per capita output.
Higher labor force growth rates in the neoclassical model reduce the equilibrium capital-to-labor ratio and output per worker.
During the transition to the steady state, economies can experience growth rates different from the steady-state rate.
Rapid growth above the steady-state rate occurs when countries begin accumulating capital.
The neoclassical model predicts convergence of per capita incomes between developed and developing countries over time.
The neoclassical model has been criticized for treating technological progress as exogenous and for the prediction that saving rates do not affect long-run growth.
Endogenous Growth Theory: Attempts to explain technological progress within the model, often through externalities from investment in knowledge and human capital, leading to non-diminishing returns to capital at the aggregate level.
In endogenous growth models, faster capital accumulation can lead to permanently faster growth in output per capita.
Subsidizing R&D and new technologies with network externalities is more likely to lead to permanent growth enhancement in endogenous growth models compared to subsidizing all private investment (which primarily leads to capital deepening).

Convergence Hypotheses

Convergence means that countries with low per capita incomes grow faster than those with high per capita incomes, narrowing the income gap.
Absolute convergence: Developing countries will eventually catch up with developed countries in per capita output (not directly implied by the basic neoclassical model).
Conditional convergence: Convergence occurs if countries have the same saving rate, population growth rate, and production function, leading to the same steady-state level of per capita output and growth rate (implied by the neoclassical model).
Club convergence: Only groups of countries (clubs) with similar characteristics converge, while others may diverge.
Convergence can occur through capital accumulation (with a larger impact in developing countries due to lower initial capital levels) and technology imitation/adoption from advanced countries.
Technology transfer requires investment in mastering and applying the technology.
The endogenous growth model does not necessarily predict convergence; countries starting with high per capita income and more capital may grow faster due to externalities.
Appropriate legal, political, and economic institutions, as well as trade policy, appear important for convergence.

Growth In An Open Economy

Governments may provide incentives to private investment in technology and knowledge due to positive externalities and spillover effects that benefit the entire economy, increasing social returns beyond private returns.
Removing trade barriers is expected to increase capital investment (due to larger markets and competition), impact profits (increased competition but larger market access), affect employment and wages (potential shifts based on comparative advantage), and promote overall economic growth through efficiency gains and technology transfer.
Free trade allows greater exploitation of economies of scale and increases the potential reward for innovation.
Countries can import technology, increasing technological progress.
Global trade increases domestic competition, forcing firms to improve products and productivity.
The neoclassical model suggests convergence should occur more quickly with open economies, free trade, and international borrowing/lending, leading to faster capital-to-labor ratio convergence.
Capital-poor countries may run trade deficits as they borrow globally for investment, while developed countries may run surpluses as they export capital.
Capital inflows can temporarily raise the growth rate in capital-poor countries above the steady state.
As developing countries accumulate capital, their wages and per capita income should converge toward those of advanced economies.
Openness of economies (reliance on foreign investment and open markets) can explain differences in growth rates among countries with similar initial income levels.
High rates of business investment and an export-driven policy focusing on manufactured goods have been drivers of convergence for some countries.
Foreign direct investment can be a major factor underlying growth.
Potential GDP growth can be estimated using growth accounting with data on capital stock, labor, and TFP.
The labor productivity method can also estimate potential GDP growth based on labor force growth and labor productivity growth.
Steady-state growth rate in the neoclassical model depends on TFP growth and labor force growth.
Growth based on capital deepening alone may not be sustainable in the long run.