CHAPTER 11

ECONOMIC GROWTH AND THE

INVESTMENT DECISION
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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 economys growth.
The focus of economic growth is on the long-term trend in aggregate output.

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2. GROWTH IN THE GLOBAL ECONOMY:

DEVELOPED VS. DEVELOPING COUNTRIES
GDP and per capita GDP are indicators of economic development and standard
of living.
or
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.
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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

Well developed

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

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REAL GDP GROWTH

Real GDP Growth
0%

Advanced Economies
Developing Countries
Argentina
Botswana
Brazil
China
Ethiopia
Germany
Hong Kong
India
Japan
Mexico
Singapore
United States
Vietnam

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2%

4%

Annual Growth Rate in Real GDP

6%
8%
10%
12%
14%
16%

18%

19711980
20012010

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 ( is earnings):
Examining changes over time:

Note: The percentage change in earnings share of GDP is approximately zero over the
long term.

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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.

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4. DETERMINANTS OF ECONOMIC GROWTH

The CobbDouglas production function is
F(K, L) = KL1

(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).
1. Constant returns to scale (increasing input increases output)
2. Diminishing marginal productivity for each input

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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.
Output
per
Worker

Increase
in TFP
g
Capital deepenin

Capital per Worker

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GROWTH ACCOUNTING
If is the elasticity of output with respect to capital, the growth accounting
equation is
Y/Y
Growth
rate of
output

A/A
Rate of
technological
change

K/K
Growth
rate of
capital

(1 )

L/L
Growth
rate of
labor

We can use this equation to estimate potential GDP, using trends of labor and
capital and estimating the elasticity, , as 1 minus the labor share of GDP.
An alternative is the labor productivity growth accounting equation:

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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:
1. Countries may fail to develop economic institutions necessary for growth.
2. 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).
3. Nonrenewable natural resources may eventually limit growth (that is,
depletion of the resource) unless TFP results in more efficient use of
resources.

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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 countrys sustainable rate of
economic growth.

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FACTORS INFLUENCING ECONOMIC GROWTH

Economic growth is affected by
1. 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.
2. 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.
3. Technology
- Technology affects both human and physical capital.
4. Public infrastructure investment
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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.

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Neoclassical Model
(Solow model)

Endogenous Growth
Theory

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.

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.

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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.

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PER CAPITA INCOME

Real GDP per Capita in USD
$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

Argentina
Botswana
Brazil
China
Ethiopia
Germany
Hong Kong

1950

1970

1990

2010

India
Japan
Mexico
Singapore
United States
Vietnam

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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.

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RELATIONSHIP BETWEEN
GROWTH AND INCOME
6%

Average
Annual Growth
Rate in
5%
Real GDP

China

4%
3%

France

2%
1%
0%
$0

US

Kenya
Venezuela
$2,000 $4,000 $6,000 $8,000 $10,000$12,000$14,000$16,000
Per Capita Income in USD

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6. GROWTH IN AN OPEN ECONOMY

Opening an economy affects the growth of the economy because
1. investment is not constrained by domestic savings.
2. countries can shift resources to those goods and services for which they have
a comparable advantage.
3. access to the global market for selling goods and services allows for
economies of scale.
4. countries can import technology.
5. global trading increases competition in the local market.

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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.

Growth slows as the

return on investment
gradually declines and
the trade deficit
shrinks.

The rate of growth

increases above the
steady-state growth.

Developing countries
run a trade deficit.

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CONCLUSIONS AND SUMMARY

The sustainable rate of economic growth is measured by the rate of increase in
the economys 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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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 economys 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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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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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
economys growth rate only in the short run, so long-run growth depends
solely on population growth, progress in total factor productivity, and labors
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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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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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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