1. Chapter 11 economic Growth and the Investment Decision
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2. 1. Introduction
Measuring and forecasting growth and the factors that contribute to growth are important in valuation and portfolio management.
Forecasting growth requires understanding the drivers to an economy’s growth.
The focus of economic growth is on the long-term trend in aggregate output.
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3. 2. Growth in the Global Economy: Developed vs. Developing countries
GDP and per capita GDP are indicators of economic development and standard of living.
Economic growth = Annual percentage change in real GDP or
Economic growth = Annual percentage change in per capita GDP
Comparing real GDP allows for a comparison of standards of living.
Comparing growth in real GDP per capita allows for a comparison of changes in the standard of living.
Purchasing power parity (PPP) is the theory that exchange rates change so that the purchasing power in different countries is the same.
The cost of a basket of goods and services is the same across different countries.
Problems with adjusting a currency using market exchange rates: Rates are volatile and affected by financial flows in tradable goods and services.
LOS: Describe and compare factors favoring and limiting economic growth in developed and developing economies.
Pages 622–630
Notes to the presenter:
Purchasing power parity was discussed in Chapter 10 as well in the context of exchange rates (exchange rates in the long run).
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4. Growth in the Global Economy: Developed vs. Developing countries
Factor
Limiting Growth
Favoring Growth
Rate of savings and investment
Low rate
High rate
Financial markets
Poorly developed
Well developed
Legal system
Corrupt or weak
Property rights
Lacking
Well defined
Education and health services
Poor
Good
Policies regarding entrepreneurship
High tax and restrictive regulations
Low tax and few regulations
International trade and flow of capital
Restrictive
Open
LOS: Describe and compare factors favoring and limiting economic growth in developed and developing economies.
Pages 622–630
High rates of savings and investment, well-developed financial markets, a well-developed legal system, well-defined property rights, good education and health services, low taxes and few regulations, and open international trade favor economic growth. Low rates of savings and investment, poorly developed or nonexistent financial markets, corrupt or weak legal systems, lack of property rights, poor education and health services, high taxes, high degree of regulations, and restrictive trade limit economic growth.
Notes to the presenter:
Example 11-1 illustrates what happens when policies change from favoring growth to limiting growth.
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5. Real GDP growth
LOS: Describe and compare factors favoring and limiting economic growth in developed and developing economies.
Pages 622–630
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6. 3. Why potential growth matters to investors
Potential GDP is the maximum output an economy can produce without resulting in an increase in inflation.
Real earnings growth cannot exceed the growth rate of potential GDP.
Relationship (𝐸 is earnings):
Aggregate value of equities = 𝑃=GDP 𝐸 GDP 𝑃 𝐸
Examining changes over time:
Percentage change in stock market values = Percentage change in GDP + Percentage change in earnings share of GDP + Percentage change in earnings multiple
Note: The percentage change in earnings share of GDP is approximately zero over the long term.
LOS: Describe the relationship between the long-run rate of stock market appreciation and the sustainable growth rate of the economy.
Pages 631–633
The percentage change in the value of businesses is a function of the percentage change in GDP plus the percentage change in earnings’ share of GDP (which is close to zero in the long run) and the percentage change in the earnings multiple (that is, P/E). Hence, real earnings growth cannot exceed the sustainable growth rate of potential GDP in the long run.
Notes to the presenter:
Exhibit 11-3 reports on the returns on the S&P 500 Index and the growth rates in GDP, earnings, and the multiple. Real GDP growth in the United States is close to 3% per year.
Real GDP growth rates for a large number of countries are provided in Exhibit 11-1 (p. 623–624).
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7. Relevance to fixed-income investors
Potential growth rate in GDP is important for fixed-income investors because it
affects economic forecasts of growth.
is used to gauge inflationary pressures.
is used to forecast real interest rate.
influences rate of GDP growth on credit quality.
affects monetary policy because the deviation between actual and potential GDP (the output gap) is a measure of resource utilization in the economy.
affects the perceived risk of sovereign debt.
affects fiscal policy.
LOS: Explain the importance of potential gross domestic product (GDP) and its growth rate in the investment decisions of equity and fixed-income investors.
Pages 633–635
The potential growth rate in GDP is important for fixed-income investors because it affects economic forecasts of growth, monetary policy, and fiscal policy, and it is used to gauge inflationary pressures and to forecast real interest rates. The potential growth rate in GDP also affects credit quality of corporate and sovereign debt.
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8. 4. Determinants of economic growth
The Cobb–Douglas production function is
F(K, L) = KαL1 – α (11-2)
which means that the output (the quantity produced) is a function of the inputs — capital (K) and labor (L) — and the marginal product of capital is the ratio of capital income to output (that is, GDP).
Constant returns to scale (increasing input → increases output)
Diminishing marginal productivity for each input
LOS: Distinguish between capital deepening investment and technological progress and explain the impact of each on economic growth and labor productivity.
Page 636
Notes to the presenter:
A production function is a relationship between inputs (capital and labor) and outputs.
A production may relate only one factor (e.g., labor) to output (e.g., very short run), but the more useful functions use both capital and labor as factors of production.
A production function may depict increasing returns to scale, constant returns to scale, or diminishing returns to scale.
The Cobb–Douglas function as specified in the text refers to the constant returns to scale (exponents on K and L sum to 1.0).
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9. Capital deepening and TFP
Total factor productivity (TFP) is the level of productivity or technology in an economy.
Technological progress is the improvement in technology, and an improvement in technology shifts the entire production function.
Capital deepening is an increase in the capital-to-labor ratio.
It will increase output, but sustained economic growth cannot occur with capital deepening alone.
Increase in TFP
LOS: Distinguish between capital deepening investment and technological progress and explain the impact of each on economic growth and labor productivity.
Pages 637–640
Capital deepening is an increase in the capital-to-labor ratio, whereas technological progress is the improvement in technology that increases labor productivity. Capital deepening will result in more capital per worker and some increase in the output per worker, but an increase in technological progress will increase the output per worker at all levels of capital per worker.
Notes to the presenter:
The graph in this slide is similar to that in Exhibit 11-4.
Capital deepening is also referred to as capital intensity.
Capital widening, a related term, is when capital and labor are increasing at the same rate.
Capital deepening
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10. Rate of technological change
Growth Accounting
If a is the elasticity of output with respect to capital, the growth accounting equation is
We can use this equation to estimate potential GDP, using trends of labor and capital and estimating the elasticity, a, as 1 minus the labor share of GDP.
An alternative is the labor productivity growth accounting equation:
Growth rate in potential GDP = Long−term growth rate of labor force + Long−term growth rate in labor productivity
∆Y/Y =
∆A/A + a
∆K/K
(1 – a)
∆L/L
Growth rate of output
Rate of technological change
Growth rate of capital
Growth rate of labor
LOS: Forecast potential GDP based on growth accounting relations.
Pages 640–641
Estimating the elasticity of output with respect to capital as 1 minus the labor share of GDP, we estimate the potential GDP as the sum of (1) the rate of technological change, (2) the product of elasticity and the growth rate of capital, and (3) the product of 1 minus the elasticity and the growth rate of labor.
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11. Natural resources and economic growth
Access to natural resources is important for economic growth; it is not necessary for a country to own or produce natural resources.
Problems associated with ownership and production of natural resources:
Countries may fail to develop economic institutions necessary for growth.
Currency appreciation from exports of natural resources causes other segments of the economy to become uncompetitive in the global market, which results in contraction and a lack of TFP progress (Dutch disease).
Nonrenewable natural resources may eventually limit growth (that is, depletion of the resource) unless TFP results in more efficient use of resources.
LOS: Explain the impact of natural resources on economic growth, and evaluate the argument that limited availability of natural resources constrains economic growth.
Pages 642–644
Access to natural resources is important for economic growth; it is not necessary for a country to own or produce natural resources.
There are problems associated with ownership and production of natural resources, including that countries may fail to develop economic institutions necessary for growth, currency appreciation from exports of natural resources causes other segments of the economy to become uncompetitive in the global market, and nonrenewable natural resources may eventually limit growth (that is, depletion of the resource) unless there is more a efficient use of resources.
Notes to the presenter:
The phenomenon that an abundance of natural resources does not necessarily lead to economic growth is a crowding-out effect: Natural capital crowds out physical capital and human capital.
Example 11-4 (p. 643–644) illustrates the issue with respect to proven oil reserves.
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12. Labor force participation and growth
The labor force participation rate is the percentage of working age population in the labor force.
An increase in this rate may raise per capita GDP.
Recent increases in this rate reflect the increased participation of women in the labor force.
When comparing countries, demographics (e.g., age, gender) explains some of the differences in this rate.
Immigration may offset the declining birthrates in developed countries.
Countries may encourage or discourage immigration.
The growth rate of labor productivity affects a country’s sustainable rate of economic growth.
LOS: Explain the effects of demographics, immigration, and labor force participation on the rate and sustainability of economic growth.
Pages 645–649
The increase in the proportion of women in the workforce has increased the labor force participation rate in recent decades, contributing to economic growth.
The increase in the working age population enhances economic growth, and the increase in immigration may mitigate the effects of declining birthrates and mortality in countries in which the working age population is not increasing.
Notes to the presenter:
Migration is highlighted in Exhibit 11-7: Greater growth in population related to liberal immigration policies helped Spain and Ireland achieve growth rates of GDP greater than that the rest of the EU.
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13. Factors influencing economic growth
Economic growth is affected by
Labor
The average hours worked per worker affects the contribution of labor to output.
The quality of the labor force (that is, human capital) is a source of growth.
Capital stock
There is a positive relationship between investment in the physical stock and growth.
Growth in capital stock alone will not sustain growth.
Composition of the physical capital matters to growth.
Technology
Technology affects both human and physical capital.
Public infrastructure investment
LOS: Explain how investment in physical capital, human capital, and technological development affects economic growth.
Pages 649–663
Labor, capital stock investment, enhancement of technology, and public infrastructure investment all contribute to economic growth. Capital stock alone cannot sustain growth, but it can affect growth in the short term.
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14. 5. Theories of growth Classical Model (Mathusian theory)
Adopting new technology results in a larger population, but not a greater standard of living.
There is no growth per capita output.
Neoclassical Model (Solow model)
The growth rate of output is equal to the growth rate of labor force and growth in total factor productivity, such that sustaining growth requires technological progress.
Technological progress is exogenous to this model.
Over time, per capita incomes of developed and developing countries converge.
Endogenous Growth Theory
Growth arises from the enhancement of human capital from improvements in technology and more efficient production.
Technology is not exogenous; rather, the model seeks to explain technological progress.
Savings and investment decisions affect economic growth.
LOS: Compare classical growth theory, neoclassical growth theory, and endogenous growth theory.
Pages 663–680
In the classical model, adopting new technology results in a larger population, but not a greater standard of living. There is no growth per capita output to new technology.
According to the neoclassical model, the growth rate of output is equal to the growth rate of labor force and growth in total factor productivity, such that sustaining growth requires technological progress. Technological progress is exogenous to this model. Over time, per capita incomes of developed and developing countries converge.
Endogenous growth theory explains that growth arises from the enhancement of human capital from improvements in technology and more efficient production.
Notes to the presenter:
The neoclassical model is attributed to Solow (his 1956 and 1957 articles).
Endogenous growth theory is a result of the work by Arrow (1962), Romer (1986), and Lucas (1988), among others.
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15. Converge or not to converge?
Convergence is the situation in which the per capita income of developing countries converge toward that of developed countries.
Absolute convergence: Per capita income of developing countries will equal that of developed countries.
Conditional convergence: Per capita income of developing countries will equal that of developed countries if they have the same rate of savings, population growth rate, and production function.
Club convergence: Middle and rich countries (“in the club”) converge on the richest countries’ per capita income, but those not in the club do not.
Nonconvergence trap: Some countries (“not in the club”) fail to converge because of the lack of institutional reforms.
Convergence can take place through developing countries’ capital accumulation and capital deepening or by developing countries imitating or adopting the technology of advanced countries.
LOS: Explain and evaluate convergence hypotheses.
Pages 680–684
Convergence is the situation in which the per capita income of developing countries converge toward that of developed countries.
Absolute convergence occurs when the per capita income of developing countries equals that of developed countries, whereas conditional convergence occurs only when the countries have the same rate of savings, population growth rate, and production function.
There is club convergence when some countries converge, but others do not, and nonconvergence occurs when there is a failure of some countries (“not in the club”) to converge because of the lack of institutional reforms.
Convergence can take place through developing countries’ capital accumulation and capital deepening or by developing countries imitating or adopting the technology of advanced countries.
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16. Per capita income LOS: Explain and evaluate convergence hypotheses.
Pages 680–684
Notes to the presenter:
This is a chart based on data in Exhibit
You can see the convergence in per capita income in several countries—notably, Hong Kong and Japan.
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17. Convergence and investment
Convergence can take place
through capital accumulation and capital deepening or
by imitating or adopting the technology of advanced countries.
Developing countries can grow faster (and achieve convergence) if they adopt or develop new technologies.
Therefore, spending on research and development assists convergence.
Prediction: Inverse relationship between initial level of per capita real GDP and the growth rate in per capita GDP.
LOS: Explain the economic rationale for governments to provide incentives to private investment in technology and knowledge.
Pages 680–684
Developing countries can grow faster (and achieve convergence) if they adopt or develop new technologies. Therefore, governments providing incentives for spending on research and development (R&D) assists convergence.
Notes to the presenter:
An example of a way in which governments provide incentives for R&D is tax credits.
Relationship between per capita real GDP and growth rate in per capita GDP is shown in Exhibit
The neoclassical model does not predict convergence; rather, it predicts that countries with more capital and higher per capita income will grow faster while it is difficult for developing countries to catch up.
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18. Relationship between Growth and income
China
France US
LOS: Explain the economic rationale for governments to provide incentives to private investment in technology and knowledge.
Pages 680–684
Notes to the presenter:
This illustration is based on the data shown in Exhibit
You can see the negative relationship between GDP growth and per capita income.
Kenya
Venezuela
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19. 6. Growth in an open economy
Opening an economy affects the growth of the economy because
investment is not constrained by domestic savings.
countries can shift resources to those goods and services for which they have a comparable advantage.
access to the global market for selling goods and services allows for economies of scale.
countries can import technology.
global trading increases competition in the local market.
LOS: Describe the expected impact of removing trade barriers on capital investment and profits, employment and wages, and growth in the economies involved.
Pages 684–693
Opening an economy affects the growth of the economy because
investment is not constrained by domestic savings.
countries can shift resources to those goods and services for which they have a comparable advantage.
access to the global market for selling goods and services allows for economies of scale.
countries can import technology.
global trading increases competition in the local market.
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20. Dynamic adjustment process for Developing countries
Developing countries have lower capital per worker, so the marginal product of capital is higher.
Global investors seek out the higher marginal product of capital.
Physical stock of developing countries grows.
Developing countries run a trade deficit.
The rate of growth increases above the steady-state growth.
Growth slows as the return on investment gradually declines and the trade deficit shrinks.
LOS: Describe the expected impact of removing trade barriers on capital investment and profits, employment and wages, and growth in the economies involved.
Page 685
Notes to the presenter:
This diagram is the process whereby developing countries develop.
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21. Conclusions and Summary
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 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.
Equity markets respond to anticipated growth in earnings. Higher sustainable economic growth should lead to higher earnings growth and equity market valuation ratios, all else being equal.
The best estimate for the long-term growth in earnings for a given country is the estimate of the growth rate in potential GDP.
The growth rate of earnings cannot exceed the growth in potential GDP in the long run.
For global fixed-income investors, a critical macroeconomic variable is the rate of inflation.
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22. Conclusions and Summary
One of the best indicators of short- to intermediate-term inflation trends is the difference between the growth rate of actual and potential GDP.
Capital deepening occurs when the growth rate of capital (net investment) exceeds the growth rate of labor.
An increase in total factor productivity causes a proportional upward shift in the entire production function.
One method of measuring sustainable growth estimates 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 long-term growth rate of the labor force plus the long-term growth rate of labor productivity.
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23. Conclusions and Summary
The forces driving economic growth include the quantity and quality of labor and the supply of capital, raw material, 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 long-run economic growth and the rate of investment is high.
Technology is a major factor determining total factor productivity, and total factor productivity is the main factor affecting long-term, sustainable economic growth rates in developed countries.
Once the weighted contributions of all explicit factors (e.g., labor and capital) are accounted for, total factor productivity is the residual component of growth.
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24. Conclusions and Summary
Growth in labor productivity depends on capital deepening and technological progress.
Three important theories on growth are the classical, neoclassical, and new endogenous growth models.
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, so long-run growth depends solely on population growth, progress in total factor productivity, and labor’s share of income.
The neoclassical model assumes that the production function exhibits diminishing marginal productivity with respect to any individual input.
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25. Conclusions and Summary
The main criticism of the neoclassical model is that it provides no quantifiable prediction of the rate or form of total factor productivity change; total factor productivity progress is exogenous to the model.
Endogenous growth theory explains technological progress within the model rather than treating it as exogenous. As a result, self-sustaining 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, 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.
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26. Conclusions and Summary
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 trade-oriented economies will grow at a faster rate.
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