Refresher Reading
Economic Growth and the Investment Decision
2020 Curriculum CFA Program Level II Economics
Introduction
Forecasts of longrun economic growth are important for global investors. Equity prices reflect expectations of the future stream of earnings, which depend on expectations of future economic activity. This means that in the long term, the same factors that drive economic growth will be reflected in equity values. Similarly, the expected longrun growth rate of real income is a key determinant of the average real interest rate level in the economy, and therefore the level of real returns in general. In the shorter term, the relationship between actual and potential growth (i.e., the degree of slack in the economy) is a key driver of fixed income returns. Therefore, in order to develop global portfolio strategies and investment return expectations, investors must be able to identify and forecast the factors that drive longterm sustainable growth trends. Based on a country’s longterm economic outlook, investors can then evaluate the longterm investment potential and risk of investing in the securities of companies located or operating in that country.
In contrast to the shortrun fluctuations of the business cycle, the study of economic growth focuses on the longrun trend in aggregate output as measured by potential GDP. Over long periods of time, the actual growth rate of GDP should equal the rate of increase in potential GDP because, by definition, output in excess of potential GDP requires employing labor and capital beyond their optimum levels. Thus, 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 the key to raising the level of income, the level of profits, and the living standard of the population. Even small differences in the growth rate translate into large differences in the level of income over time.
What drives longrun growth? What distinguishes the “winners” from the “losers” in the longrun growth arena? Will poor countries catch up with rich countries over time? Can policies have a permanent effect on the sustainable growth rate? If so, how? If not, why not? These and other key questions are addressed in detail in this reading.
The reading is organized as follows: Section 2 examines the longterm growth record, focusing on the extent of growth variation across countries and across decades. Section 3 discusses the importance of economic growth to global investors and examines the relationship between investment returns and economic growth. Section 4 examines the factors that determine longrun economic growth. Section 5 presents the classical, neoclassical, and endogenous growth models. It also discusses whether poorer countries are converging to the higher income levels of the richer countries. Finally, Section 6 looks at the impact of international trade on economic growth. A summary and practice problems complete the reading.
Learning Outcomes
The member should be able to:
 compare factors favoring and limiting economic growth in developed and developing economies;

describe the relation between the longrun rate of stock market appreciation and the sustainable growth rate of the economy;

explain why potential GDP and its growth rate matter for equity and fixed income investors;

distinguish between capital deepening investment and technological progress and explain how each affects economic growth and labor productivity;

forecast potential GDP based on growth accounting relations;

explain how natural resources affect economic growth and evaluate the argument that limited availability of natural resources constrains economic growth;

explain how demographics, immigration, and labor force participation affect the rate and sustainability of economic growth;

explain how investment in physical capital, human capital, and technological development affects economic growth;

compare classical growth theory, neoclassical growth theory, and endogenous growth theory;

explain and evaluate convergence hypotheses;

describe the economic rationale for governments to provide incentives to private investment in technology and knowledge;
 describe the expected impact of removing trade barriers on capital investment and profits, employment and wages, and growth in the economies involved.
Summary
This reading focuses on the factors that determine the longterm growth trend in the economy. As part of the development of global portfolio equity and fixedincome strategies, investors must be able to determine both the nearterm and the sustainable rates of growth within a country. Doing so requires identifying and forecasting the factors that determine the level of GDP and that determine longterm sustainable trends in economic growth.

The sustainable rate of economic growth is measured by the rate of increase in the economy’s productive capacity or potential GDP.

Growth in real GDP measures how rapidly the total economy is expanding. Per capita GDP, defined as real GDP divided by population, measures the standard of living in each country.

The growth rate of real GDP and the level of per capita real GDP vary widely among countries. As a result, investment opportunities differ by country.

Equity markets respond to anticipated growth in earnings. Higher sustainable economic growth should lead to higher earnings growth and equity market valuation ratios, all other things being equal.

The best estimate for the longterm growth in earnings for a given country is the estimate of the growth rate in potential GDP.

In the long run, the growth rate of earnings cannot exceed the growth in potential GDP. Labor productivity is critical because it affects the level of the upper limit. A permanent increase in productivity growth will raise the upper limit on earnings growth and should translate into faster longrun earnings growth and a corresponding increase in stock price appreciation.

For global fixedincome investors, a critical macroeconomic variable is the rate of inflation. One of the best indicators of short to intermediateterm inflation trends is the difference between the growth rate of actual and potential GDP.

Capital deepening, an increase in the capitaltolabor ratio, occurs when the growth rate of capital (net investment) exceeds the growth rate of labor. In a graph of output per capita versus the capitaltolabor ratio, it is reflected by a move along the curve (i.e., the production function).

An increase in total factor productivity (TFP) causes a proportional upward shift in the entire production function.

One method of measuring sustainable growth uses the production function and the growth accounting framework developed by Solow. It arrives at the growth rate of potential GDP by estimating the growth rates of the economy’s capital and labor inputs plus an estimate of total factor productivity.

An alternative method measures potential growth as the longterm growth rate of the labor force plus the longterm growth rate of labor productivity.

The forces driving economic growth include the quantity and quality of labor and the supply of nonICT and ICT capital, public capital, raw materials, and technological knowledge.

The labor supply is determined by population growth, the labor force participation rate, and net immigration. The physical capital stock in a country increases with net investment. The correlation between longrun economic growth and the rate of investment is high.

Technological advances are discoveries that make it possible to produce more or higher quality goods and services with the same resources or inputs. Technology is a major factor determining TFP. TFP is the main factor affecting longterm, sustainable economic growth rates in developed countries and also includes the cumulative effects of scientific advances, applied research and development, improvements in management methods, and ways of organizing production that raise the productive capacity of factories and offices.

Total factor productivity, estimated using a growth accounting equation, is the residual component of growth once the weighted contributions of all explicit factors (e.g., labor and capital) are accounted for.

Labor productivity is defined as output per worker or per hour worked. Growth in labor productivity depends on capital deepening and technological progress.

The academic growth literature is divided into three theories —the classical view, the neoclassical model, and the new endogenous growth view.

In the classical model, growth in per capita income is only temporary because an exploding population with limited resources brings per capita income growth to an end.

In the neoclassical model, a sustained increase in investment increases the economy’s growth rate only in the short run. Capital is subject to diminishing marginal returns, so longrun growth depends solely on population growth, progress in TFP, and labor’s share of income.

The neoclassical model assumes that the production function exhibits diminishing marginal productivity with respect to any individual input.

The point at which capital per worker and output per worker are growing at equal, sustainable rates is called the steady state or balanced growth path for the economy. In the steady state, total output grows at the rate of labor force growth plus the rate of growth of TFP divided by the elasticity of output with respect to labor input.

The following parameters affect the steady state values for the capitaltolabor ratio and output per worker: saving rate, labor force growth, growth in TFP, depreciation rate, and elasticity of output with respect to capital.

The main criticism of the neoclassical model is that it provides no quantifiable prediction of the rate or form of TFP change. TFP progress is regarded as exogenous to the model.

Endogenous growth theory explains technological progress within the model rather than treating it as exogenous. As a result, selfsustaining growth emerges as a natural consequence of the model and the economy does not converge to a steady state rate of growth that is independent of saving/investment decisions.

Unlike the neoclassical model, where increasing capital will result in diminishing marginal returns, the endogenous growth model allows for the possibility of constant or even increasing returns to capital in the aggregate economy.

In the endogenous growth model, expenditures made on R&D and for human capital may have large positive externalities or spillover effects. Private spending by companies on knowledge capital generates benefits to the economy as a whole that exceed the private benefit to the company.

The convergence hypothesis predicts that the rates of growth of productivity and GDP should be higher in the developing countries. Those higher growth rates imply that the per capita GDP gap between developing and developed economies should narrow over time. The evidence on convergence is mixed.

Countries fail to converge because of low rates of investment and savings, lack of property rights, political instability, poor education and health, restrictions on trade, and tax and regulatory policies that discourage work and investing.

Opening an economy to financial and trade flows has a major impact on economic growth. The evidence suggests that more open and tradeoriented economies will grow at a faster rate.