LM02 Economic Growth and the Investment Decision 2023 Level II Notes

LM02 Economic Growth and the Investment Decision

1. An Introduction to Growth in the Global Economy ................................................................................3

1.1 Growth in the Global Economy: Developed vs. Developing Economies .................................3
2. Factors Favoring and Limiting Economic Growth ..................................................................................4
2.1 Financial Markets and Intermediaries ................................................................................................4
2.2 Political Stability, Rule of Law, and Property Rights .....................................................................5
2.3 Education and Health Care Systems ....................................................................................................5
2.4 Tax and Regulatory Systems ...................................................................................................................5
2.5 Free Trade and Unrestricted Capital Flows ......................................................................................5
2.6 Summary of Factors Limiting Growth in Developing Countries ...............................................6
3. Why Potential Growth Matters to Investors .............................................................................................6
4. Economic Growth: Production Function and Growth Accounting ...................................................8
4.1 Production Function...................................................................................................................................8
4.2 Growth Accounting .....................................................................................................................................9
4.3 Extending the Production Function .................................................................................................. 10
5. Capital Deepening vs. Technological Progress ...................................................................................... 11
6. Natural Resources ............................................................................................................................................ 11
7. Labor Supply....................................................................................................................................................... 12
8. ICT and Non- ICT, Technology, and Public Infrastructure ................................................................ 13
8.1 Technology .................................................................................................................................................. 13
8.2 Public Infrastructure ............................................................................................................................... 13
9. Summary of Economic Growth Determinants....................................................................................... 14
10. Theories of Growth........................................................................................................................................ 14
10.1 Classical Model........................................................................................................................................ 14
10.2 Neoclassical Model ................................................................................................................................ 14
11. Implications of Neoclassical Model ......................................................................................................... 15
12. Extension of Neoclassical Model .............................................................................................................. 16
13. Endogenous Growth Model ........................................................................................................................ 17
14. Convergence Hypothesis ............................................................................................................................. 17
15. Growth in an Open Economy ..................................................................................................................... 18
Summary................................................................................................................................................................... 20

This document should be read in conjunction with the corresponding reading in the 2023 Level II
CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright
2022, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights
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LM02 Economic Growth and the Investment Decision 2023 Level II Notes

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LM02 Economic Growth and the Investment Decision 2023 Level II Notes

1. An Introduction to Growth in the Global Economy

Global investment managers often rely on forecasts of long-term economic growth to decide
which parts of the world to invest in. This reading will help us identify and understand the
factors that determine the long-term growth trend in an economy.
The reading covers:
 Long term growth record of developed and developing economies
 The importance of economic growth to fixed income and equity investors
 The factors that determine long-run economic growth
 Theories of economic growth - Classical, Neoclassical, and Endogenous growth
models
 Impact of international trade on economic growth
1.1 Growth in the Global Economy: Developed vs. Developing Economies
Economic growth is measured as the annual percentage change in real GDP or in real GDP
per capita.
Real GDP is a measure of the total economic output of a country or region. Growth in real
GDP tells us how quickly the total economy is growing.
Real GDP per capita is measured as the total economic output of a country divided by the
country’s population. It reflects the average standard of living of a country. Real GDP per
capita grows if the real GDP grows at a faster rate than the population. Growth in real GDP
per capita implies a rising standard of living.
Exhibit 1 of the curriculum presents data on the growth rate of GDP and the level of per
capita GDP for various countries. (Sample data for a few countries is presented below). To
facilitate comparison the data has been converted into a common currency – the US dollar
using exchange rates implied by purchasing power parity PPP.
Avg yearly Real GDP Growth (%) Real GDP per capita in Dollars*
1971- 1981 - 1991 - 2001 - 1950 1970 1990 2010
1980 1990 2000 2010
Developed 3.2 3.1 2.8 1.6
Canada 4.0 2.8 2.4 1.8 $12,053 $19,919 $13,1969 $41,288
United States 3.1 2.9 3.4 1.6 14,559 22,806 35,328 46,697
Developing 6.2 6.9 7.4 8.5
China 10.4 9.1 10.4 10.5 402 698 1,677 8,569
India 3.9 5.9 5.6 7.5 658 922 1,390 3,575
Ethiopia 3.0 1.9 2.9 8.4 314 479 462 749
Sources: International Monetary Fund, World Economic Outlook database for growth rates, and Conference
Board, total economy database (September 2011)

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LM02 Economic Growth and the Investment Decision 2023 Level II Notes

The economies in Exhibit 1 are divided into two categories:

 Developed economies – These are economies with high per capita GDP. GDP growth
in the large, developed economies has generally slowed over the last few decades. For
example, United States and Canada.
 Developing economies – These are economies with low per capita GDP. GDP for
developing countries is generally growing at a faster rate than developed countries.
However, there is significant variation in economic performance among the
developing countries. For example, China and India are growing at a rapid rate,
whereas Latin America, Africa, and the Middle East are growing at a relatively slower
rate.
Instructor’s Note: Refer to the ‘Real GDP per capita in Dollars’ section of the exhibit. Given
data like this, you should be able to calculate the growth rate. For example, the growth rate
in real GDP per capita for China from 1990 to 2010, can be calculated as: PV = 1677, FV = -
8569, PMT = 0, N =20; CPT I/Y  I/Y = 8.5%.
Similarly, the growth rate in real GDP per capita for Ethiopia for the same time period can be
calculated as: PV = 462, FV = -749, PMT = 0, N = 20; CPT I/Y  I/Y = 2.4%
Let’s look at some of the factors that will help us understand why some countries grow at a
faster rate while others grow at a slower rate.

2. Factors Favoring and Limiting Economic Growth

To enable growth, a country needs capital. Capital increases productivity, which in turn
increases the GDP growth rate. For example, a farmer using a tractor will be more
productive than a farmer using a bullock cart.
The capital comes from private and public sector investments. When people save money, the
money is invested and converted into physical capital. A general problem with developing
economies is that savings are low because people’s incomes are low. This creates a vicious
cycle of poverty: Low savings rate leads to less investments, which leads to slow GDP
growth, which leads to low income and savings. But this problem can be addressed by
attracting foreign investments into the economy.
2.1 Financial Markets and Intermediaries
Along with a high savings rate, growth also depends on how well savings are allocated
within the economy. Good and efficient financial markets can help enable growth. Good
financial markets encourage investments, which means more capital is available in the
economy.
Efficient financial markets:
 help allocate funds to projects with the highest risk-adjusted returns.
 create investment instruments that facilitate risk transfer, diversification, and

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LM02 Economic Growth and the Investment Decision 2023 Level II Notes

enhance liquidity.
 make it easier for companies to raise capital.
For example, banks can combine small amounts of savings from multiple individuals into a
larger pool which can be used to finance larger projects. Evidence shows that countries with
better-functioning financial markets and intermediaries grow at a faster rate.
2.2 Political Stability, Rule of Law, and Property Rights
A stable and effective government, well-developed legal and regulatory system, and respect
for property rights stimulates economic growth.
For example, property rights create incentives for households and companies to invest and
save, and a good legal system ensures that these rights are protected. On the other hand,
political instability creates economic uncertainty, which discourages the flow of capital.
2.3 Education and Health Care Systems
Countries with good education systems will have more productive workers. Similarly,
healthier people will be more productive. Thus, education and health care systems
contribute to GDP growth.
Empirical studies show that developed countries should focus on higher education, whereas
developing economies should focus on primary and secondary education for greater impact
on their respective economies.
2.4 Tax and Regulatory Systems
Business-friendly tax and regulatory systems that encourage entrepreneurship are good for
economic growth.
2.5 Free Trade and Unrestricted Capital Flows
Opening an economy to capital can have a major impact on economic growth. Foreign
investment can occur in two ways:
1. Foreign Direct Investment (FDI): Direct investment by building or buying property,
plant, and equipment.
2. Foreign Portfolio Investment (FPI): Indirect investment by buying debt and equity
securities issued by domestic companies.
Both forms of foreign investment are beneficial to the economy. The curriculum provides the
examples of Brazil and India that have benefitted from foreign investments.
Apart from capital flows, free trade also benefits an economy. Residents get access to more
goods at a lower cost. Domestic companies face increased competition, which forces them to
be more productive and efficient.

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LM02 Economic Growth and the Investment Decision 2023 Level II Notes

2.6 Summary of Factors Limiting Growth in Developing Countries

Factors limiting growth include the following:
 Low saving and investment
 Poorly developed financial markets
 Weak and corrupt legal systems; poor law enforcement
 Lack of property rights
 Political instability
 Poor public education and health services
 Tax and regulatory policies which discourage entrepreneurship
 Restrictions on trade and capital flow
Instructor’s Note: The items in this list are opposites of the factors that enable growth.

3. Why Potential Growth Matters to Investors

Equity and fixed income valuations are closely related to the growth rate of the economy.
Equity Investors
The aggregate value of the stocks can be expressed as the product of three factors.
E P
P = GDP ( )( )
GDP E
where: P represents the aggregate price of stocks and E represents the aggregate
earnings.
In the short run, all three factors fluctuate and contribute to the change in stock prices.
However, in the long run, the aggregate price of stocks will move with GDP. The aggregate
earnings to GDP ratio and P/E ratio will trend towards a long-term average value.
Exhibit 2 of the curriculum shows US after-tax corporate profits as a percentage of GDP.
Corporate profits as a percentage of GDP have averaged around the 6% level. If the share of
profits in GDP rose above the mean level, then at some point, stagnant labor income would
make workers unwilling to work. This would weaken demand and stop further profit
growth. Thus, in the long run, the real earnings growth cannot exceed the growth rate of
potential GDP.

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Similarly, the price-to-earnings ratio cannot increase or decrease forever because investors
will not pay an illogically large price for a unit of earnings, nor will they give away earnings
for nothing.
Exhibit 3 of the curriculum shows the decomposition of S&P 500 returns over the period
1946-2007.
Annual return/Growth rate Standard Deviation
S&P 500 return 10.82% 15.31%
Real GDP growth 3.01 2.97
Inflation 3.94 3.29
EPS/GDP -0.12 17.62
P/E 0.32 23.80
Dividend yield 3.67 1.49
Total 10.82
Source: Stewart, Piros, and Heisler (2011).
During this period, the S&P 500 returns were 10.82%, of which the dividend yield was
3.67%. Hence, the index price went up by approximately 10.82 – 3.67 = 7.15%. The nominal
GDP growth is a combination of the real GDP growth (3.01%) and inflation (3.94%), so we
can see that the nominal GDP has gone up by 6.95%. The data indicates that the increase in
stock prices is approximately the same as the increase in nominal GDP. We can also see that
the combined effect of EPS/GDP and P/E is very small (0.2%). Also, they have a relatively
high standard deviation. So, a major part of variation of prices can be attributed to the
variation of these two ratios. In the long run, the aggregate prices of stocks and GDP have a

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LM02 Economic Growth and the Investment Decision 2023 Level II Notes

very stable relationship.

Fixed Income Investors
Changes in potential GDP allow us to gauge inflationary pressures in the economy. If we have
a situation where the actual GDP growth rate is above the potential GDP growth rate, then
this will give rise to inflation. High inflation is an issue for fixed income investors as it
reduces the real value of future cash flow streams.
If we have high potential GDP growth rate, we will also have high real interest rate. This will
mean that the expected real asset returns are also higher.
In general, high potential GDP growth improves credit quality of fixed income securities.
This is because if an economy does well, the companies that have issued the fixed income
securities also tend to do well, improving their chances of making the debt payments.
Monetary policy decisions are affected by the difference between actual and potential GDP.
Thus, fixed income investors need to monitor the output gap closely to predict changes in
central bank policy.
Growth rate of potential GDP is one of the variables that credit rating agencies look at while
assigning sovereign debt ratings. All else equal, a higher growth rate generally means better
ratings.
The difference between actual and potential GDP also impacts the fiscal policy. Government
budget deficits usually increase during recessions and decrease during expansions.

4. Economic Growth: Production Function and Growth Accounting

In the following sections, we will discuss various factors such as capital, labor, technology,
natural resources, etc. which contribute to economic growth.
4.1 Production Function
A production function is the link between the factors of production and output. A basic two
factor production function is shown below:
Y = A × F(K, L)
where:
Y = Aggregate output in the economy
L = Quantity of labor
K = Quantity of capital
A = Total factor productivity (Generally interpreted as level of technology)
The function F(K,L) means that capital and labor can be used in various combinations to
produce output. An increase in A (total factor productivity) indicates a proportionate
increase in output for any combination of inputs.

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Let’s look at a simple example of a production function, the Cobb-Douglas production

function. It is given by:
Y = A[K ∝ L1−∝ ]
The parameter α represents the share of GDP paid to suppliers of capital and has a value
between 0 and 1. (1- α) represents the share of GDP paid to labor.
Two important properties of the Cobb-Douglas production function are:
 Constant returns to scale: If all inputs are increased by the same percentage, then
output increases by the same percentage. For example, if both capital and labor are
increased by 5% each, then the output will also increase by 5%.
 Diminishing marginal productivity with respect to each individual input: Marginal
productivity is the extra output produced from a one-unit increase in an input
keeping the other inputs unchanged. Diminishing marginal productivity means that at
some point the extra output obtained from each additional unit of the input will
decline.
Labor productivity is a measure of the amount of goods a worker can produce. It can be
derived by multiplying the Cobb-Douglas production function by 1/L:
Y/L = AF(K/L, L/L) = AF(K/L, 1)
Defining y = Y/L as the labor productivity and k = K/L as the capital-to-labor ratio, the above
expression becomes:
y = AF(k, 1) = Akα
According to this equation, the amount of goods a worker can produce (labor productivity)
depends on the amount of capital available for each worker (capital-to-labor ratio),
technology or TFP, and the share of capital in GDP (α).
4.2 Growth Accounting
Growth accounting is used to analyze the performance of economies. The (Solow) growth
accounting equation is as follows:
ΔY/Y = ΔA/A + αΔK/K + (1 – α) ΔL/L
or
Growth rate of output = rate of technological change + α (growth rate of capital) + (1 – α)
(growth rate of labor).
Since a 1% increase in capital leads to an α% increase in output, α is the elasticity of output
with respect to capital. Similarly, (1 – α) is the elasticity of output with respect to labor.
Thus, in the Cobb–Douglas production function, the exponents α and (1 – α) can be
interpreted as both output elasticities and the shares of income paid to each factor.

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LM02 Economic Growth and the Investment Decision 2023 Level II Notes

For example, in the United States, the relative shares of labor and capital are approximately
0.7 and 0.3, respectively. This means that a 1% increase in capital will increase output by
only 0.3%, whereas a 1% increase in labor will increase output by 0.7%.
The growth accounting equation is used to:
1. Estimate the contribution of technological progress: The growth in TFP can be
calculated as a residual in the above equation by plugging in ΔY/Y, ΔK/K, ΔL/L, and α
and solving for ΔA/A. This residual measures the amount of output that cannot be
explained by growth in capital or labor.
2. Measure sources of growth: We can decompose growth into growth due to
technological progress, growth due to capital deepening and growth due to increase
in labor.
3. Measure potential output: We can estimate potential GDP by using trend estimates of
labor and capital. TFP is treated as an exogenous variable and is estimated using
other techniques.
An alternative method of measuring potential GDP is the labor productivity growth
accounting equation. Under this approach, the equation for estimating the potential GDP is:
Growth rate in potential GDP = Long-term growth rate of labor force + Long-term growth
rate in labor productivity
4.3 Extending the Production Function
The production function discussed in Section 4.1 focused on only the labor and capital
inputs. The list of inputs caan be expanded to include the following:
 Raw materials: natural resources such as oil, lumber, and available land (N)
 Quantity of labor: the number of workers in the country (L)
 Human capital: education and skill level of these workers (H)
 Information, computer, and telecommunications capital (ICT): computer hardware,
software, and communication equipment (KIT)
 Non-ICT capital: transport equipment, metal products and plant machinery other
than computer hardware and communications equipment, and non-residential
buildings and other structures (KNT)
 Public capital: infrastructure owned and provided by the government (KP)
 Technological knowledge: the production methods used to convert inputs into final
products, reflected by total factor productivity (A)
The expanded production function is expressed as: Y = AF(N, L, H, KIT, KNT, KP)

5. Capital Deepening vs. Technological Progress

Exhibit 4 of the curriculum shows the relationship between output per worker and capital

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LM02 Economic Growth and the Investment Decision 2023 Level II Notes

per worker. Growth in per capita output can come from two sources: capital deepening and
improvement in technology.

Capital deepening means an increase in the capital to labor ratio. It is shown by a move
along the production function from point A to point B. Due to diminishing marginal
productivity, adding more and more capital to a fixed number of workers increases per
capita output but at a decreasing rate. At some point, the marginal product of capital will be
equal to its marginal cost and companies will stop adding more capital. Once the economy
reaches this stage, capital deepening cannot be a source of sustained growth in the economy.
Technological progress, represented by an increase in total factor productivity, causes an
upward shift in the entire production function. As a result, the economy can produce higher
output per worker for a given level of capital per worker. This is shown by the move from B
to C. Thus, technological progress can help mitigate the limit imposed by capital deepening.
Sustained growth in per capita output requires progress in TFP. This is particularly true for
advanced economies which already have a high level of capital per worker.

6. Natural Resources
Natural resources are an important input to growth. There are two categories of natural
resources:
 Renewable resources which can be replenished. For example, forests.
 Non-renewable resources which are finite and are depleted once they are consumed.
For example, oil and coal.
Even though countries with more natural resources are expected to grow faster, this is not
always the case and the relationship between natural resources and growth is complex.

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LM02 Economic Growth and the Investment Decision 2023 Level II Notes

Access to natural resources is important, ownership is not.

Some countries such as Japan and South Korea have grown rapidly but have few natural
resources. Whereas, countries like Venezuela and Saudi Arabia have not grown much
although they have large oil reserves.
For some countries, the presence of natural resources may even limit growth. This can
happen for two reasons:
 Countries rich in natural resources may fail to develop the economic institutions
necessary for growth.
 Countries may suffer from Dutch disease, where currency appreciation makes other
segments of the economy, particularly manufacturing, globally uncompetitive.
There is a long-standing concern that the eventual depletion of non-renewable resources
will eventually limit economic growth. However, this is not a major issue because as
resources get used up, their price will increase and substitutes will be developed. For
example, alternative sources of energy are already being developed as a substitute for oil.

7. Labor Supply
Labor is an important source of economic growth. Growth in labor supply depends on four
factors:
1. Population growth: It is determined by fertility rates and mortality rates. Population
growth is high in developing countries and low in developed countries. The age mix of
the population is also important. An increase in the working age population (age 16-
64) is considered positive.
2. Labor force participation rate: The labor force participation rate is the percentage
of the working age population in the labor force. It can increase if more women enter
the work force. It should, however, be noted that growth due to an increasing labor
force participation represents a temporary trend as the participation rate cannot
keep increasing indefinitely.
3. Net migration: Developed countries with declining labor force can encourage
immigration. For example, Canada.
4. Average hours worked: Average hours worked per worker also affects the
contribution of labor to overall output. In advanced countries, the long-term trend in
average working hours has been towards a shorter work-week. This is due to
multiple factors such as: legislation limiting the number of hours worked, an increase
in part-time and temporary work opportunities, high taxes on labor income, and the
“wealth effect”, which causes workers in high-income countries to value leisure time
more.
Labor Quality: Human Capital
Apart from the quantity of labor, the quality of labor force also contributes towards the

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LM02 Economic Growth and the Investment Decision 2023 Level II Notes

growth of an economy. Human capital is the accumulated knowledge and skills that workers
acquire from education, training, or life experience. In general, better educated and well-
trained workers produce more output. Education and on-the-job training improve the
quality of human capital.
Also, human capital has spillover effects. Knowledgeable workers are more likely to innovate
and contribute towards technological progress.

8. ICT and Non- ICT, Technology, and Public Infrastructure

We can divide capital into two types: ICT (Information, Computers and Telecom) and Non-
ICT (non-residential construction, transport equipment, machinery). Countries that devote a
large share of GDP to investment, such as China, India and South Korea, have high growth
rates.
The ICT sector has led to substantial increase in the rate of economic and productivity
growth due to network externalities. The more people in the network, the greater the
potential productivity gains.
Non-ICT spending should eventually result in capital deepening and thus have less impact on
potential GDP growth. However, ICT spending may actually boost the growth rate of
potential GDP, because of its externality impacts.
8.1 Technology
Technology includes the combined effects of scientific advances, applied research and
development, improvements in management methods, and ways of organizing production
that raise productive capacity of factories and offices. Technology is reflected in human
capital, machinery, equipment and software. Technological progress allows an economy to
produce more output (or better-quality output) with the same amount of input and
overcome some of the limits of diminishing marginal returns of capital. It results in an
upward shift in the production function.
8.2 Public Infrastructure
The final component of the capital input is public infrastructure investment. Examples of
public capital include roads, bridges, municipal water, dams, and electric grids. Public
infrastructure complements the production of private sector goods and services. They also
have huge externalities.

9. Summary of Economic Growth Determinants

Growth accounting can be used to understand the sources of contribution to GDP growth.
The table below from the curriculum shows the different components that contributed to the
growth in GDP in United States and India.
Contribution from:

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LM02 Economic Growth and the Investment Decision 2023 Level II Notes

Labor Labor Non- ICT ICT TFP (%) Growth in

Quantity Quality (%) Capital (%) Capital GDP (%)
(%) (%)
United States
1995 – 2005 0.6 0.3 0.7 0.8 0.9 3.3
2005 - 2009 0.1 0.1 0.5 0.5 -0.5 0.7
India
1995 - 2005 1.0 0.2 2.7 0.5 1.9 6.3
2005 - 2008 1.1 0.1 3.7 0.9 2.4 8.2

10. Theories of Growth

The three theories of economic growth that we will discuss are the classical, neoclassical and
endogenous growth models.
10.1 Classical Model
The classical growth theory was developed by Thomas Malthus and is commonly referred to
as Malthusian theory. It assumes that when the per capita income rises above the
subsistence income, the population growth accelerates. The population grows to the extent
that the per capita income comes back to subsistence level.
Thus, the predictions of the classical model are:
 Growth in real GDP per person is temporary.
 In the long run, the adoption of new technology results in a larger but not a richer
population.
Empirical evidence, however, does not support this model. As the growth of per capita
income increased, population growth slowed down instead of increasing. Rapid
technological progress offsets the impact of diminishing marginal returns.
10.2 Neoclassical Model
This model was devised by Robert Solow in the 1950’s. The objective of the Neoclassical
model is to determine the relationship between long growth rate and
1. Savings and investment rate
2. Rate of technological change
3. Population growth
The neoclassical model is based on the Cobb-Douglas production function. According to this
model, as economies develop, they eventually reach steady state. In steady state, capital per
worker and output per worker grow at equal sustainable rates. This is also called the
balanced growth path. Capital deepening still occurs, but it has no effect on the growth rate
of the economy or on the marginal product of capital once the steady state is reached.
Instead, the long-run per capita growth depends on exogenous technological progress.
Three important relationships to remember are,

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LM02 Economic Growth and the Investment Decision 2023 Level II Notes

θ
1. Growth rate of output per capita = 1−α
θ
2. Growth rate of output = 1 − α + n
Y 1 θ
3. Output per unit of capital = = ( ) [( ) + δ + n]
K s 1−α

where:
ɵ = Growth rate of total factor productivity
1 - α = Elasticity of output with respect to labor
n = Growth rate of labor
s = Saving rate
δ = Depreciation of capital

11. Implications of Neoclassical Model

There are four major groups of conclusions from the neoclassical model (Sec 11 of the
curriculum)
1. Capital Accumulation
a. Capital accumulation affects the level of output but not the growth rate in the long
run.
b. Regardless of its initial capital-to-labor ratio or initial level of productivity, a growing
economy will move to a point of steady state growth.
c. In a steady state, the growth rate of output equals the rate of labor force growth plus
the rate of growth in TFP scaled by labor’s share of income [n + θ/(1 – α)]. The
growth rate of output does not depend on the accumulation of capital or the rate of
business investment.
2. Capital Deepening vs. Technology
a. Rapid growth that is above the steady state rate of growth occurs when countries first
begin to accumulate capital, but growth will slow as the process of accumulation
continues.
b. Long-term sustainable growth cannot rely solely on capital deepening investment—
that is, on increasing the stock of capital relative to labor. If the capital-to-labor ratio
grows too rapidly (i.e., faster than labor productivity), capital becomes less
productive, resulting in slower rather than faster growth.
c. More generally, increasing the supply of some input(s) too rapidly relative to other
inputs will lead to diminishing marginal returns and cannot be the basis for
sustainable growth.
d. In the absence of improvements in TFP, the growth of labor productivity and per
capita output would eventually slow.
e. Because of diminishing marginal returns to capital, the only way to sustain growth in
potential GDP per capita is through technological change or growth in total factor

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LM02 Economic Growth and the Investment Decision 2023 Level II Notes

productivity. This results in an upward shift in the production function—the

economy produces more goods and services for any given mix of labor and capital
inputs.
3. Convergence
a. Given the relative scarcity and hence high marginal productivity of capital and
potentially higher saving rates in developing countries, the growth rates of
developing countries should exceed those of developed countries.
b. As a result, there should be a convergence of per capita incomes between developed
and developing countries over time.
4. Effect of Savings on Growth
a. The initial impact of a higher saving rate is to temporarily raise the rate of growth in
the economy. In response to the higher saving rate, growth exceeds the steady state
growth rate during a transition period. However, the economy returns to the
balanced growth path after the transition period.
b. During the transition period, the economy moves to a higher level of per capita
output and productivity.
c. Once an economy achieves steady state growth, the growth rate does not depend on
the percentage of income saved or invested. Higher savings cannot permanently raise
the growth rate of output.
d. However, countries with higher saving rates will have a higher level of per capita
output, a higher capital-to-labor ratio, and a higher level of labor productivity.

12. Extension of Neoclassical Model

Neoclassical model has the following limitations:
# Neoclassical Model Says: But…
Most growth in developed
1 Technology impact is a residual countries has come from
increases in TFP
Steady state growth rate is unrelated to Evidence of positive correlation
2 saving and investment rate (but rather between savings rate and
depends on technology and labor growth) growth rate
If capital stock rises faster than labor
For advanced countries the
3 productivity then return on investment
evidence suggests otherwise
will decline
Hence, an extended neoclassical model was developed by adding inputs like human capital
and R&D to the production function. However, this approach was still insufficient to address
limitation # 2 & 3.

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LM02 Economic Growth and the Investment Decision 2023 Level II Notes

13. Endogenous Growth Model

In contrast to the neoclassical model, endogenous growth theory models focus on explaining
technological progress rather than treating it as exogenous. Unlike the neoclassical model,
which assumes diminishing marginal returns to capital, the endogenous growth models
assume investment in capital can have constant returns. Thus, increasing the saving rate can
permanently increase the rate of economic growth.
According to the endogenous growth theory, spending on R&D has positive externalities that
benefit the whole economy. Individual companies capture only a part of the benefits
associated with their R&D investments. Therefore, from a societal point of view, private
companies may under-invest in R&D. Government incentives can help correct this market
failure by making R&D investments more lucrative to private companies.
Finally, according to this model, there is no reason why the incomes of developed and
developing countries should converge.
The equation for growth rate of output is:
∆ye/ye = ∆ke/ke = sc – δ – n
where:
ye = output per worker
ke = capital per worker
c = output to capital ratio
s = Saving rate
δ = Depreciation of capital
According to this model:
1. the output per worker (ye) always grows at the same rate as capital per worker (ke).
2. a higher saving rate (s) implies a permanently higher growth rate.
14. Convergence Hypothesis
Convergence means that countries with low per capita incomes should grow at a faster rate
than countries with high per capita income and their income levels should eventually
converge.
The Neoclassical model predicts two types of convergence:
 Absolute convergence implies that developing countries, regardless of their
particular characteristics, will eventually catch up with the developed countries and
match them in per capita output.
 Conditional convergence implies that convergence is conditional on the countries
having the same saving rate, population growth rate and production function. If these
conditions hold, the model implies convergence to the same level of per capita output

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LM02 Economic Growth and the Investment Decision 2023 Level II Notes

as well as the same steady state growth rate.

Empirical evidence suggests that some of the poorer countries are diverging rather than
converging to the income levels of the developed countries. This leads us to the concept of
club convergence: only rich and middle-income countries that are members of the club are
converging to the income level of the richest countries of the world. Countries with the
lowest per capita income in the club grow at the fastest rate.
Countries outside the club may fall into a non-convergence trap. These are countries
which do not implement necessary institutional reforms and their income levels are moving
further away from the income levels of developed countries.

15. Growth in an Open Economy

The original Solow model assumes a closed economy where domestic investment equals
domestic savings. This is a problem for poor countries which have a low savings rate.
Opening up the economy to trade and financial flows is likely to have the following benefits
for such countries:
1. Investments are not limited by domestic savings. Domestic investments can be
funded by global savings.
2. Countries can focus on industries in which they have a comparative advantage.
3. Companies have access to a larger, global market resulting in economies of scale.
4. Countries can import technology, thus increasing the rate of technological progress.
5. Increased competition from global markets, forces companies to produce better
products, improve productivity, and keep costs low.
According to the neoclassical model, open economies will converge faster because
capital/labor ratio will converge faster. The adjustment process can be described as follows:
1. The rate of return on investments should be higher in countries with low capital-to-
labor ratios (developing countries) and lower in countries with high capital-to-labor
ratios (developed countries).
2. Therefore, capital should flow from developed countries to developing countries.
3. Due to the capital inflows, developing countries should grow more rapidly than
developed countries and the per capita incomes should converge.
4. Since capital flows must be matched by offsetting trade flows, developing countries
will tend to run a trade deficit, as they import capital, and the developed countries
will tend to run trade surpluses, as they export capital.
5. The inflows of capital will temporarily raise the rate of growth in developing
countries above the steady state rate of growth. At the same time, growth in the
capital-exporting countries will be below the steady state.
6. Eventually investment rate and trade deficit will decline; if investment falls below
domestic saving, the country will shift towards a trade surplus and become an

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LM02 Economic Growth and the Investment Decision 2023 Level II Notes

exporter of capital.
7. In the Solow model, there is no permanent increase in the rate of growth in an
economy. Both the developed and developing countries grow at the steady state rate
of growth.
In contrast to the neoclassical model, endogenous growth models predict that a more open
trade policy will permanently raise the rate of economic growth because:
1. Global competition forces less efficient companies to exit and more efficient
companies to innovate and become more efficient.
2. It allows producers to more fully exploit economies of scale by selling to a larger
market.
3. Less advanced countries or sectors of an economy catching up with the more
advanced countries or sectors through knowledge spillovers.
In general, open and trade-oriented economies will grow faster than closed economies.

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LM02 Economic Growth and the Investment Decision 2023 Level II Notes

Summary
LO: Compare factors favoring and limiting economic growth in developed and
developing economies.
Factors that enable growth include:
 Savings and investment
 Financial markets and intermediaries
 Political stability, rule of law, and property rights
 Education and health care systems
 Tax and regulatory systems
 Free trade and unrestricted capital flows
If these factors are either absent or negative then they limit growth.
LO: Describe the relation between the long- run rate of stock market appreciation and
the sustainable growth rate of the economy.
In the long run, the rate of stock market appreciation will be equal to the sustainable growth
rate of the economy.
LO: Explain why potential GDP and its growth rate matter for equity and fixed income
investors.
For equity investors, the best estimate for the long-term growth in earnings for a given
country is the estimate of the growth rate in potential GDP.
For global fixed-income investors, the difference between the growth rate of actual and
potential GDP helps predict inflation, which is a key macroeconomic variable.
LO: Contrast capital deepening investment and technological progress and explain
how each affects economic growth and labor productivity.
Capital deepening is an increase in the capital-to-labor ratio. It is reflected by a move along
the production function. Adding more and more capital to a fixed number of workers
increases per capita output but at a decreasing rate.
An increase in total factor productivity (TFP) causes a proportional upward shift in the
entire production function.
LO: Demonstrate forecasting potential GDP based on growth accounting relations.
Growth rate of output = rate of technological change + α (growth rate of capital) + (1 – α)
(growth rate of labor)
Growth rate in potential GDP = Long-term growth rate of labor force + Long-term growth
rate in labor productivity
LO: Explain how natural resources affect economic growth and evaluate the argument

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LM02 Economic Growth and the Investment Decision 2023 Level II Notes

that limited availability of natural resources constrains economic growth.

Even though countries with more natural resources are expected to grow faster, this is not
always the case and the relationship between natural resources and growth is complex.
Some countries such as Japan and South Korea have grown rapidly but have few natural
resources, whereas countries like Venezuela and Saudi Arabia have not grown much
although they have large oil reserves.
LO: Explain how demographics, immigration, and labor force participation affect the
rate and sustainability of economic growth.
The quantity of labor depends on population growth, labor force participation rate, net
migration, and average hours worked.
LO: Explain how investment in physical capital, human capital, and technological
development affects economic growth.
 The forces driving economic growth include the quantity and quality of labor and the
supply of non-ICT and ICT capital, public capital, raw materials, and technological
knowledge.
 Technological progress allows an economy to produce more output with the same
amount of input and overcome some of the limits of diminishing marginal returns of
capital. It results in an upward shift in the production function.
 Labor productivity is defined as output per worker or per hour worked. Growth in
labor productivity depends on capital deepening and technological progress.
LO: Compare classical growth theory, neoclassical growth theory, and endogenous
growth theory.
 The classical growth theory assumes that when the per capita income rises above the
subsistence income, the population growth accelerates. The population grows so
much that the per capita income comes back to subsistence level.
 In the neoclassical model, the long run growth rate of GDP depends solely on
population growth, progress in TFP, and labor’s share of income. A sustained increase
in investment increases the economy’s growth rate temporarily.
 In contrast to the neoclassical model, endogenous growth theory models focus on
explaining technological progress rather than treating it as exogenous. Unlike the
neoclassical model, that assumes diminishing marginal returns to capital, in the
endogenous growth models investment in capital can have constant returns. So,
increasing the saving rate can permanently increase the rate of economic growth.
LO: Explain and evaluate convergence hypotheses.
 Absolute convergence implies that developing countries, regardless of their particular
characteristics, will eventually catch up with the developed countries and match them

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LM02 Economic Growth and the Investment Decision 2023 Level II Notes

in per capita output.

 Conditional convergence implies that convergence is conditional on the countries
having the same saving rate, population growth rate and production function. If these
conditions hold, the model implies convergence to the same level of per capita output
as well as the same steady state growth rate.
LO: Describe the economic rationale for governments to provide incentives to private
investment in technology and knowledge.
According to the endogenous growth theory, spending on R&D has positive externalities that
benefit the whole economy. Individual companies capture only a part of the benefits
associated with their R&D investments. Therefore, from a societal point of view, private
companies may under-invest in R&D. Government incentives can help correct this market
failure by making R&D investments more lucrative to private companies.
LO: Describe the expected impact of removing trade barriers on capital investment
and profits, employment and wages, and growth in the economies involved.
Opening an economy to financial and trade flows has a major impact on economic growth. In
general, open and trade-oriented economies will grow faster than closed economies.

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