Economic Growth and Investment

Table of Contents
1. READING 6 ECONOMIC GROWTH
2. EXAM FOCUS
3. MODULE 6.1: GROWTH FACTORS AND PRODUCTION FUNCTION
4. MODULE 6.2: GROWTH ACCOUNTING AND INFLUENCING FACTORS
5. MODULE 6.3: GROWTH AND CONVERGENCE THEORIES
6. KEY CONCEPTS
7. ANSWER KEY FOR MODULE QUIZZES
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READING 6 ECONOMIC GROWTH

EXAM FOCUS

Forecasts of economic growth rates have important implications for investment decisions. Understand the preconditions of growth, how the growth rate can be increased, and what drives economic growth. Be able to compare and contrast competing theories of growth. Finally, be able to use growth accounting equations to forecast the potential growth rate of an economy.

MODULE 6.1: GROWTH FACTORS AND PRODUCTION FUNCTION

LOS 6.a: Compare factors favoring and limiting economic growth in developed and developing economies.

Economists measure the economic output of a country by gross domestic product (GDP). A country's standard of living is best measured by GDP per capita. Of particular concern to investors is not just the level of economic output but the growth rate of output.

Historically, there have been large variations in both GDP growth rates and per capita GDP across countries. Research has identified several factors that influence both the growth of GDP and the level of GDP. The preconditions and institutions that support growth differ across developed and developing economies; below are the primary factors that are positively related to economic growth and explanations of how they operate.

Preconditions for growth

• Savings and investment. Savings and investment are positively correlated with economic development. For countries to grow, private and public sector investment must provide a sufficient level of capital per worker. If domestic savings are insufficient, foreign investment must be attracted to raise capital per worker and support growth.
• Financial markets and intermediaries. Financial markets and intermediaries augment economic growth by efficiently allocating resources: they identify users of capital with the best risk-adjusted returns, create financial instruments that provide liquidity and risk sharing, and pool small savings to finance large projects. Caution: financial intermediation can also produce declining credit standards or excessive leverage, increasing financial risk but not necessarily increasing economic growth.
• Political stability, rule of law, and property rights. A stable political environment, enforceable laws, and secure property rights (for both physical and intellectual property) are essential for attracting and protecting capital. Wars, corruption, weak rule of law, or policy uncertainty reduce investor confidence and growth.
• Human capital investment. Investment in skills, education, and health (human capital) is complementary to physical capital. Countries investing in education and healthcare tend to have higher growth. Developed countries gain most from post-secondary education that fosters innovation; less-developed countries benefit most from primary and secondary education that enables workers to apply existing technologies.
• Tax and regulatory environment. Tax and regulatory systems affect incentives to invest and innovate. All else equal, lower tax and regulatory burdens foster entrepreneurial activity and productivity growth.
• Free trade and unrestricted capital flows. Free trade increases competition, improves efficiency, opens new markets, and allows economies of scale. Unrestricted capital flows allow countries with insufficient domestic savings to obtain foreign capital-either directly via foreign direct investment (FDI) in physical assets or indirectly via portfolio investment in financial assets-supporting higher capital accumulation and growth.

LOS 6.b: Describe the relation between the long-run rate of stock market appreciation and the sustainable growth rate of the economy.

Equity prices are positively related to earnings growth. Aggregate corporate earnings can grow if GDP grows or if the share of corporate earnings in GDP grows. However, the corporate share of GDP cannot increase indefinitely because labour will be unwilling to accept an ever-declining share. Therefore, potential GDP-the upper limit of real growth for an economy-is an important constraint on long-run aggregate earnings growth and thus on long-run stock market appreciation.

The Grinold-Kroner (2002) decomposition provides a practical framework:

E(R) = dividend yield (DY) + expected capital gains yield (CGY)

Decompose the expected capital gains yield:

expected capital gains yield = EPS growth (ΔEPS) + expected repricing (ΔP/E)

Decompose EPS growth into real EPS growth, inflation, and change in shares outstanding (dilution):

EPS growth = real EPS growth (ΔEPSR) + inflation (π) - change in shares outstanding (ΔS)

Therefore the full model is:

E(R) = DY + ΔEPSR + π - ΔS + ΔP/E

Notes on the components:

• Dividend yield (DY) tends to be stable over time.
• ΔP/E (repricing) fluctuates with the business cycle: when GDP growth is strong and perceived risk declines, market multiples can rise. The repricing term cannot grow indefinitely.
• ΔEPSR (real EPS growth) is the key long-run driver of returns; it is itself bounded by the economy's potential GDP growth.
• ΔS (dilution) is the net change in shares outstanding: net issuance minus buybacks. For aggregate markets, net issuance combines public issuance, buybacks, and the effect of private firms entering public markets; the degree to which small and medium entrepreneurial firms contribute to issuance is termed the economy's relative dynamism (rd). Thus ΔS = nbb + rd, where nbb is net buybacks (or net issuance) and rd captures the dynamism of privately held firms issuing stock.

LOS 6.c: Explain why potential GDP and its growth rate matter for equity and fixed income investors.

All else equal, higher GDP growth supports higher equity returns because aggregate earnings can expand. However, equity returns are affected by dilution (share issuance and buybacks) and by the distribution of growth across public and private firms.

Potential GDP has important implications for real interest rates and fixed income investors. If potential GDP growth is positive, future incomes are expected to rise relative to current incomes. Consumers anticipating higher future incomes may save less now and consume more, implying that investments must offer higher real returns to induce saving. Therefore, higher potential GDP growth tends to imply higher real interest rates and higher real asset returns in general.

In the short term, the gap between actual GDP and potential GDP is informative:

• If actual GDP exceeds potential GDP, upward pressure on prices and inflation is likely; this matters particularly for fixed-income investors.
• Central banks monitor this gap: actual > potential increases inflation concerns and may induce restrictive monetary policy; actual < potential="" encourages="" expansionary="">
• Governments are more likely to run fiscal deficits when actual GDP growth is below potential.
• Credit risk: higher potential GDP growth reduces expected credit risk for corporate and government borrowers and improves credit quality.

LOS 6.d: Contrast capital deepening investment and technological progress and explain how each affects economic growth and labor productivity.

Factor inputs and economic growth

To analyse growth, we commonly use an aggregate production function with two factors: labour (L) and capital (K), given a level of technology (T). A widely used functional form is the Cobb-Douglas production function:

Y = T · K^α · L^1-α

This function states that output (Y) depends on capital and labour inputs and their productivity, scaled by technology T. The Cobb-Douglas function exhibits constant returns to scale-proportional increases in both inputs produce the same proportional increase in output.

Divide both sides by L to obtain output per worker (labour productivity):

Y / L = T · (K / L)^α

Interpreting this equation:

• Labour productivity (Y/L) is similar to GDP per worker or GDP per capita and is a measure of living standards.
• Given constant α and workforce size, increases in output per worker arise from capital deepening (increasing K/L) or from improvements in technology (increasing T), also called total factor productivity (TFP).
• Since α < 1, additional capital has diminishing marginal returns: each extra unit of capital per worker raises productivity by less than the previous unit.

Professor's note: Distinguish between marginal product of capital and marginal productivity of capital. The marginal product of capital is the additional output from one more unit of capital overall. The marginal productivity of capital is the increase in output per worker when capital per worker increases while labour is held constant.

In steady state (equilibrium), the marginal product of capital equals the rental price (the marginal cost) of capital, r. For Cobb-Douglas:

MPK = α · Y / K

Setting MPK = r gives:

α · Y / K = r

or equivalently

α = rK / Y

Professor's note: The product rK measures the return to providers of capital; rK/Y is the share of output allocated to capital, which equals α.

Graphically, productivity curves show output per worker as a function of capital per worker. Capital deepening is movement along the curve, and its effect is limited by diminishing marginal productivity. Economies will add capital until MPK = r; beyond that point, additional capital accumulation ceases to increase labour productivity.

Technological progress increases the productivity of both capital and labour and shifts the productivity curve upward. Because technology raises productivity at all levels of K/L, it can sustain continued increases in output per worker despite diminishing returns to capital.

Labour productivity growth rate = growth due to technological change + growth due to capital deepening.

Interpretation for developed vs developing countries:

• Developed countries typically have a high capital-to-labour ratio (high K/L, e.g., C1 on a productivity curve). Because α < 1 and diminishing returns are stronger when capital is already abundant, developed countries gain less from further capital deepening and depend more on technological progress (TFP) for productivity growth.
• Developing countries usually have lower capital per worker (e.g., C0). For them, capital deepening can raise productivity substantially-at least in the short to medium term-until diminishing returns set in.

MODULE 6.2: GROWTH ACCOUNTING AND INFLUENCING FACTORS

LOS 6.e: Demonstrate forecasting potential GDP based on growth accounting relations.

Growth accounting relations

Using the Cobb-Douglas production function, the growth rate of output can be expressed as a growth accounting relation:

ΔY/Y = ΔTFP + α · ΔK/K + (1 - α) · ΔL/L

Where:

• ΔY/Y is the growth rate of output (GDP).
• ΔTFP is the growth rate of total factor productivity (technology).
• α is the output elasticity (share) of capital; (1 - α) is labour's share.
• ΔK/K and ΔL/L are growth rates of capital and labour respectively.

In practice, capital and labour are forecast from long-term trends, and α is determined from national income accounts. Because ΔTFP is not directly observable, it is estimated as the residual: realised output growth minus the portion explained by observed growth in capital and labour.

The growth accounting equation is useful for isolating the comparative effects of different inputs and for estimating potential output.

Example: Estimating potential GDP growth rate (Azikland)

Azikland is an emerging market where labour's share of total factor cost is 60% (i.e., labour share = 0.6). The long-term trend of labour growth is expected to be 1.5% per year. Capital investment is growing at 3% per year. Total factor productivity (TFP) is expected to increase by 2% annually. Compute Azikland's potential GDP growth rate.

Answer:

Using the growth accounting equation:

ΔY/Y = ΔTFP + α · ΔK/K + (1 - α) · ΔL/L

Substitute known values: labour share = 0.6 so capital share α = 0.4.

Compute each term:

ΔTFP = 2%

α · ΔK/K = 0.4 × 3% = 1.2%

(1 - α) · ΔL/L = 0.6 × 1.5% = 0.9%

Sum the terms:

Potential GDP growth rate = 2% + 1.2% + 0.9% = 4.1%

Another approach emphasises labour productivity growth, which equals the sum of capital deepening and technological progress; the long-term labour productivity growth rate is therefore the same decomposition of capital and technology contributions.

LOS 6.f: Explain how natural resources affect economic growth and evaluate the argument that limited availability of natural resources constrains economic growth.

Natural resources include renewable resources (e.g., timber) and nonrenewable resources (e.g., oil and gas). The relationship between natural resources and growth is complex:

• Some resource-rich countries (e.g., Brazil) have grown rapidly, while others (some resource-rich African countries) have not.
• Resource-poor countries (e.g., Japan) have achieved high per capita GDP by accessing needed resources through trade rather than ownership.
• Ownership of abundant resources can sometimes inhibit growth if the economy focuses on resource extraction at the expense of developing other sectors.
• A phenomenon called Dutch disease arises when resource booms appreciate the domestic currency, making other exports less competitive and harming non-resource industries.

Thus, limited ownership of natural resources does not necessarily constrain growth provided resources can be accessed via trade and the economy diversifies into productive activities.

LOS 6.g: Explain how demographics, immigration, and labour force participation affect the rate and sustainability of economic growth.

Quantitative labour input increases output but does not by itself increase per capita output. Quantity of labour is defined as the size of the labour force multiplied by average hours worked. The labour force comprises working-age people who are employed or seeking work.

Labour supply factors

• Demographics. Age structure and population growth influence potential growth. An ageing population reduces the labour force; a younger population supports higher potential growth. Fertility rates determine future labour supply; declining fertility creates downward pressure on long-term labour growth.
• Labour force participation. The participation rate is the proportion of the working-age population that is active in the labour force. In many countries, increased female labour force participation has raised labour input and growth potential.
• Immigration. Immigration can offset declining native labour force growth. Developed countries with lower fertility can use immigration to maintain labour supply and growth.
• Average hours worked. Average hours worked have tended to decline in many economies due to labour legislation, a leisure/wealth effect, higher taxes on labour, and growth in part-time work. Changes in average hours affect total labour input and hence output.

Example: Impact of demographics on economic growth (Cangoria)

Data for Cangoria, a country in Asia, shows a population growth rate averaging ~1.8% per year over ten years and increasing labour force participation with a young median age. Assume average world population growth is 1.2% per year. Based on these data, comment on the likely impact of Cangoria's demographic changes on economic growth.

Answer:

Cangoria's population growth at ~1.8% is above the world average (1.2%). Combined with rising labour force participation and a young median age, labour supply growth for Cangoria is likely to be above average in coming years if these trends persist. While total output is likely to increase due to a larger labour pool, per capita GDP may not necessarily rise if output does not grow faster than the population-changes in per capita GDP depend on productivity growth as well as labour input growth.

LOS 6.h: Explain how investment in physical capital, human capital, and technological development affects economic growth.

• Human capital. Human capital comprises knowledge, skills, and health. Increasing human capital through education and experience raises worker productivity and can have positive externalities: innovations and improved practices diffuse through the economy, raising productivity beyond the original investee.
• Physical capital. Physical capital categories include infrastructure, ICT (computers and telecommunications), and non-ICT capital (machinery, transport, non-residential construction). Empirical evidence shows a strong positive correlation between physical capital investment and GDP growth.

Why does additional capital sometimes still raise growth despite diminishing returns?

• Many developing countries still have low capital-to-labour ratios; increases in capital therefore yield substantial productivity gains.
• Certain types of capital stimulate technological progress. For example, investment in IT networks generates network externalities: the value of the network rises as more users join, producing multiplicative productivity effects.

Technological development is investment in knowledge, processes, machinery, software, and human capital that raises TFP. Proxies for technology investment include R&D spending and patent counts. Developed countries rely more on R&D for growth since they have high capital stocks and slower population growth; less developed countries often adopt technologies developed elsewhere.

Public infrastructure (roads, bridges, ports) complements private investment by reducing costs and expanding the productive capacity of private projects, thereby raising total factor productivity.

MODULE QUIZ 6.1, 6.2

Use the following information to answer Questions 1 through 6.

Jay Smith, an analyst for Mako Capital, is evaluating investment prospects in Minikaz, an emerging market economy. Minikaz has experienced moderate growth in the past four years, after decades of stagnation. Smith is evaluating changes in government policies that would foster a higher level of growth. (<> )Figure 1 shows the summary of his findings.

Smith reviews a report published by the Minikaz commerce department. The report indicates that the long-term real growth rate of Minikaz GDP is 2.5%, corporate profits as a percentage of GDP increased by 2% last year, and the P/E ratio increased from 17 to 19 over the last two years. Separately, Smith also reviews World Bank reports indicating that Minikaz's potential GDP growth is 4% and that it has been experiencing actual GDP growth of approximately 2.5%. Finally, Smith reviews Minikaz's national income accounts and finds that Minikaz is experiencing both technological progress and making increased capital expenditures.

Separately, Smith evaluates the performance of Kinimaz, a neighbouring republic. Kinimaz has had labour growth of 2% over the last several years and capital growth of 3%. Labour's share of total output is estimated to be 60%. Over the same period, Kinimaz's real GDP has grown by 3.7%. Comparing the two countries, Smith notes that Kinimaz has substantially higher amounts of natural resource endowments. He concludes that Minikaz's relatively lower GDP growth is due to lack of natural resources.

1.

Which of the following actions by Minikaz's government is most likely to increase Minikaz's economic growth rate?

• A. Increasing protection for consumers through regulations.
• B. Allowing foreign financial institutions to enter the market.
• C. Expanding public domain legislation.

2.

Based on the commerce department report, what would be the most likely forecast for the long-term aggregate stock market appreciation?

• A. 2.5%.
• B. 4.5%.
• C. 11.5%.

3.

Based on World Bank report, which of the following conclusions is most likely regarding Minikaz?

• A. Inflation is 1.5%.
• B. Minikaz's government is likely to follow a restrictive fiscal policy.
• C. Minikaz's central bank is not likely to be worried about inflation.

4.

Using the Cobb-Douglas production function and the concepts of capital deepening and total factor productivity, which of the following outcomes is most likely?

• A. Minikaz will experience an increase in sustainable growth of per capita output due to the increased capital expenditures.
• B. There will be no short-term increase in per capita output.
• C. There will be both short-term and long-term increases in Minikaz's GDP growth rate.

5.

Using the Cobb-Douglas relation, total factor productivity growth for Kinimaz is closest to:

• A. 0.5%.
• B. 1.3%.
• C. 1.7%.

6.

Smith's conclusion about Minikaz's relatively lower GDP growth is most likely:

• A. correct.
• B. correct because in some cases, natural resources may inhibit economic growth.
• C. incorrect because access to natural resources is more important than ownership.

7.

Data for the labor market of countries X and Y over the past year appears next:

Both countries are expected to have moderate economic expansions over the next several years. Which of the following statements is most accurate regarding labor input of the countries in the next several years?

• A. Country X will have greater opportunities to increase labor input.
• B. Country Y will have greater opportunities to increase labor input.
• C. Neither Country X nor Country Y will be able to increase labor input.

8.

Which of the following would least likely have externality effects on output growth for an economy?

• A. Human capital investment.
• B. ICT investment.
• C. Non-ICT investment.

MODULE 6.3: GROWTH AND CONVERGENCE THEORIES

LOS 6.i: Compare classical growth theory, neoclassical growth theory, and endogenous growth theory.

Theories of economic growth are classified into three principal models that differ in their view of steady-state growth potential.

Classical growth theory

Rooted in Malthusian thinking, classical growth theory posits that when real GDP per capita rises above subsistence, population growth accelerates. The larger population increases labour supply and reduces marginal productivity of labour, eventually pushing GDP per capita back toward the subsistence level. Thus, long-run growth in real GDP per capita is not permanent. Empirical evidence does not support this strict Malthusian conclusion for modern economies.

Neoclassical growth theory

Neoclassical growth theory focuses on the long-run steady state or sustainable growth rate. The economy is at equilibrium when the output-to-capital ratio is constant; when this holds, the capital-to-labour ratio and output per worker grow at the equilibrium growth rate g*. Population growth is taken as exogenous, independent of economic conditions.

Professor's note: For neoclassical theory the steady state does not require a constant level of technology; growth can occur driven by exogenous technological progress.

With the Cobb-Douglas function, the neoclassical result for sustainable growth of output per worker (g*) is:

g* = θ / (1 - α)

where θ is the growth rate of technology (TFP) and (1 - α) is labour's share of output.

Sustainable growth of total output (G*) equals sustainable growth of output per worker plus growth of labour (ΔL):

G* = g* + ΔL

Professor's note: In this formulation, the long-run growth rate is not affected by the level of capital stock K. Capital deepening affects the level of output but, once the steady state is reached, does not change the long-run growth rate. Increased savings temporarily raise growth but not the steady-state growth rate. Developing countries, which have lower capital per worker, face less severe diminishing returns and can grow faster until convergence occurs.

Endogenous growth theory

Endogenous growth theory incorporates technological progress arising from within the economic system-investments in physical and human capital (e.g., R&D, knowledge capital) generate improvements in TFP. Under some endogenous growth models, returns to capital are non-diminishing (constant returns to capital), allowing increases in savings and investment to permanently raise the growth rate. The model emphasises externalities from private R&D: private firms may underinvest relative to the social optimum because they do not capture all social returns, justifying government support for R&D.

The key distinction with neoclassical theory is the role of capital investment in generating TFP growth: endogenous theory allows investment (e.g., R&D) to directly raise TFP and thus the steady-state growth rate, whereas neoclassical theory treats TFP growth as exogenous.

LOS 6.j: Explain and evaluate convergence hypotheses.

Empirical observations show large differences in productivity (output per capita) across countries. Convergence hypotheses address whether poorer countries catch up with richer ones.

• Absolute convergence hypothesis: Poorer countries will converge to the same level of per capita income as richer countries. This strict form assumes identical fundamentals and access to technology; empirical support is limited.
• Conditional convergence hypothesis: Convergence occurs among countries with similar structural characteristics (savings rates, population growth rates, and production functions). Under this view, countries converge to their own steady states determined by those characteristics.
• Club convergence: Countries form "clubs" of similar institutional and policy environments (e.g., similar financial markets, property rights, education, and health systems). Members of a club converge toward similar living standards; countries outside the club may not converge unless they adopt similar institutions and policies.

Empirical evidence indicates partial support for convergence: over the past half century, about two-thirds of economies with income below that of the United States experienced faster growth than the United States, but full convergence to the US standard of living has been limited. Club convergence helps explain why some countries lag despite world growth: lacking appropriate institutions, they do not join the high-growth club.

LOS 6.k: Describe the economic rationale for governments to provide incentives to private investment in technology and knowledge.

Under endogenous growth theory, private R&D and knowledge capital generate social returns (externalities) in addition to private returns. Because firms capture only part of the social benefit, the private market may underinvest in R&D relative to the social optimum. Government incentives (tax breaks, subsidies, grants) can encourage greater private spending on R&D and knowledge, aligning private incentives with the social optimum and raising long-run growth.

LOS 6.l: Describe the expected impact of removing trade barriers on capital investment and profits, employment and wages, and growth in the economies involved.

Removing trade barriers and permitting free capital flows typically produce several beneficial effects:

• Increased access to foreign savings and investment.
• Allowing countries to specialise according to comparative advantage.
• Expanded markets for domestic producers, enabling economies of scale.
• Faster diffusion of technology and higher TFP growth.
• Greater competition that reallocates resources from inefficient to efficient firms.

Predictions from growth theories in an open economy:

• Neoclassical model: Developing economies can attract foreign capital, experience rapid growth while catching up, and eventually converge to the steady-state growth rates of developed economies. The benefits of open markets are significant but may be temporary if not accompanied by structural improvements.
• Endogenous growth model: Open markets and free capital flows foster innovation and permanent increases in growth by promoting competition, knowledge spillovers, and economies of scale.

Empirical research indicates that outward-oriented policies (integration with the global economy and export promotion) tend to speed convergence of living standards, whereas inward-oriented, protectionist policies often slow growth and prevent convergence.

MODULE QUIZ 6.3

1.

Country X has output elasticity of capital of 0.6 and population growth of 2%. If total factor productivity growth is 1%, what is the sustainable growth rate in output according to neoclassical theory?

• A. 2.0%.
• B. 2.7%.
• C. 4.5%.

2.

Which of the following is the most accurate description of club convergence?

• A. Less developed countries will converge to living standards of other less developed countries.
• B. More developed countries may see their standard of living drop due to competition from less developed countries.
• C. Some less developed countries may converge to developed country living standards while others may not.

3.

A chief economist argues that government policy should include an additional tax break for research and development expenses. The economist most likely agrees with:

• A. endogenous growth theory.
• B. neoclassical theory.
• C. classical theory.

Use the following information to answer Questions 4 through 5.

Jignesh Sangani, an economist with a large asset management firm, makes the following statements about removal of barriers to trade and capital flows:

Statement 1: Removal of barriers is likely to lead to permanently higher global economic growth under the neoclassical theory.

Statement 2: Removal of barriers is likely to lead to permanently higher economic growth for developing countries only under the endogenous growth theory.

4.

Sangani's Statement 1 is most likely:

• A. correct.
• B. incorrect due to economic growth being permanent.
• C. incorrect due to economic growth being global.

5.

Sangani's Statement 2 is most likely:

• A. correct.
• B. incorrect due to economic growth being permanent.
• C. incorrect due to economic growth being limited to developing countries only.

6.

Which of the following is least likely to be associated with the law of diminishing returns?

• A. Investment in labour.
• B. Investment in knowledge capital.
• C. Investment in physical capital.

KEY CONCEPTS

LOS 6.a

Significant differences in growth rates exist between economies. The following factors are positively related to growth rate:

• Sufficient level of savings and investment.
• Development of financial markets and intermediaries.
• Political stability, sound legal systems, and property rights.
• Investment in education and healthcare.
• Lower taxes and regulatory burdens.
• Free trade and unrestricted capital flows.

LOS 6.b

In the long run, the rate of aggregate stock market appreciation is limited by the sustainable growth rate of the economy.

LOS 6.c

Potential GDP represents the maximum output without upward pressure on prices. Higher potential GDP growth increases the potential for stock returns and reduces expected credit risk for fixed-income investors, all else equal. The gap between actual and potential GDP is useful for predicting fiscal and monetary policy: if actual GDP is below potential, inflation is unlikely and policymakers are more likely to pursue expansionary measures.

LOS 6.d

Capital deepening is an increase in the capital stock per worker (K/L). Due to diminishing marginal productivity of capital, capital deepening yields limited increases in output and labour productivity when K/L is already high. Technological progress (TFP) raises productivity of both labour and capital at all levels of K/L and can permanently raise the long-term growth rate.

LOS 6.e

The growth accounting relation (ΔY/Y = ΔTFP + α ΔK/K + (1-α) ΔL/L) is the primary tool for forecasting potential GDP and decomposing sources of growth.

LOS 6.f

Natural resources can matter for growth, but ownership is not necessary if resources can be accessed via trade. Resource endowments sometimes retard diversification and harm growth (Dutch disease), so natural resource ownership is not a uniform predictor of high growth.

LOS 6.g

Quantity of labour depends on population growth, labour force participation, immigration, and average hours worked. Countries with higher population growth, higher participation rates, younger working populations, higher average hours worked, or net immigration have higher potential labour input and can grow faster, all else equal.

LOS 6.h

Growth is positively correlated with investment in physical and human capital. Technological development (R&D) is critical, particularly for developed economies that rely on TFP gains to sustain growth given high capital stocks.

LOS 6.i

Classical theory: growth in GDP per capita is temporary and reverts to subsistence due to population responses.
Neoclassical theory: sustainable growth depends on population growth, labour's share, and TFP growth; capital accumulation only temporarily affects growth.
Endogenous theory: investment in R&D and knowledge can permanently raise growth by increasing TFP within the model; government policy may be needed to correct underinvestment due to externalities.

LOS 6.j

Absolute convergence: per capita growth rates converge across all countries (not strongly supported).
Conditional convergence: convergence occurs among countries with similar savings, population growth, and production functions.
Club convergence: only countries with similar institutions/policies converge, while others lag unless they reform.

LOS 6.k

Because R&D and knowledge creation yield social returns beyond private benefits, private investment in R&D will be below the social optimum without government incentives. Subsidies or tax incentives can increase private R&D to its socially optimal level and raise long-term growth.

LOS 6.l

Open economies with free trade and capital flows grow faster: foreign capital raises investment in developing countries (neoclassical perspective), and open markets promote innovation and permanent growth improvements (endogenous perspective). Convergence of living standards tends to be faster in open economies.

ANSWER KEY FOR MODULE QUIZZES

Module Quiz 6.1, 6.2

1.

B Financial intermediary development helps foster economic growth by allowing more efficient allocation of capital and risk. ((Module 6.1, LOS 6.a))

2.

A Long-term growth in the stock market is a function of GDP growth. The other factors-profits as a percentage of GDP and P/E ratios-will have a long-term growth rate of approximately zero and will not impact a forecast of long-term growth in the stock market. ((Module 6.1, LOS 6.a))

3.

C Potential GDP can be interpreted as the highest growth that can be obtained without pressure on prices. Since actual GDP is lower than potential, there is little risk of inflation. ((Module 6.1, LOS 6.b))

4.

C Since Minikaz is a developing country, it is likely to have a low capital base. With a low capital base, increased capital expenditures will still have an impact on output per worker. Technological progress always has a positive impact on output per worker. ((Module 6.1, LOS 6.d))

5.

B Use the growth accounting relations and solve for ΔTFP.

3.7% = ΔTFP + 0.4(3%) + 0.6(2%)

ΔTFP = 3.7% - 0.4(3%) - 0.6(2%)

ΔTFP = 3.7% - 1.2% - 1.2% = 1.3%

((Module 6.2, LOS 6.e))

6.

C Empirical evidence has shown that for economic growth, access to natural resources is more important than ownership. Natural resources may inhibit growth if countries that own them do not develop other industries; however, that is not the conclusion Smith reaches. ((Module 6.2, LOS 6.f))

7.

LOS 6.g

A Country X will have the greater opportunity due to the younger workforce, potential labour input from unemployed workers, and immigration. (Module 6.2)

8.

C Both human capital and ICT investment tend to have societal spillover benefits that enhance the overall growth rate. ((Module 6.2, LOS 6.h))

Module Quiz 6.3

1.

C Using the equation from neoclassical theory, 1% / (1 - 0.6) + 2% = 4.5%. (LOS 6.i)

2.

C The notion of the club is that some nations are not in the club and will not converge. ((LOS 6.j))

3.

A Endogenous growth theory includes the concept that R&D may have external benefits, and therefore should be subsidised by the government. ((LOS 6.i))

4.

B Under the neoclassical growth theory, the benefit of open markets is temporary. ((LOS 6.i))

5.

C Under the endogenous growth theory, open markets lead to a higher rate of growth permanently for all markets. ((LOS 6.i))

6.

B Knowledge capital is a special type of public good that is not subject to the law of diminishing returns. Investment in labour and physical capital do exhibit diminishing returns, which are reflected in the shape of the productivity curve. ((LOS 6.k))