Reading 15: Economic Growth and the Investment Decision

Question 1

Compare factors favoring and limiting economic growth in developed and developing economies

Answer 1

Favoring:

1. Savings and investment
2. Financial markets and intermediaries
3. Political stability, rule of law, property rights
4. Investment in human capital
5. Tax and regulatory systems
6. Free trade and unrestricted capital flows

Limiting:

Question 2

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

Answer 2

In the long run, growth in equity prices should be equal to the GDP growth

Question 3

Explain why potential GDP and its growth rate matter for equity and fixed income investors.

Answer 3

The higher the potential GDP growth rate, high er the real rates (interest and asset returns).

Implications for FI investors:

• When actual GDP growth > potential growth, inflationary pressure is high and more likely that monetary/fiscal policy is restrictive
• Higher potential GDP growth rate reduces expected credit risk of all debt issues

Question 4

Distinguish between capital deepening investment and technological progress and explain how each afffects economic growth and labor productivity.

Answer 4

Capital deepening investment: improvement in the Capital to Labor ratio (machines per worker)

Technological progress: improvement in total factor productivity (more out of existing capital and labor)

Cobb-Douglas: Y - TKL

Affect on economic growth and labor productivity: only way you see constant increase is a constant increase in labor and capital, otherwise you see diminsihing returns

Two sources of economic growth

1. Growth in capital per worker (capital deepening)
2. Increasing technology (growth in total factor productivity)

Question 5

Forecast potential GDP based on growth accounting relations.

Answer 5

Growth accounting equation: Growth rate in potential GDP = Growth rate of total factor productivity + alpha multiplied bo the long-term growth rate of capital + one minus alpha multiplied by the long term growth rate of labor

Labor productivity growth accounting equation: Growth rate in potential GDP = long-term growth rate of labor force + long-term growth rate in labor productivity

Question 6

Explain how natural resources affect economic growth and evaluate the argument that limited availabilty of natural resources constrains economic growth.

Answer 6

Affect of NR: ownership of natural resources is not important as long as there is access (via trade). However, the ownership could hinder growth:

1. Dutch disease: ownership of natural resources pushes up the value of domestic currency to the detriment of other industries
2. Other industries may be neglected

Question 7

Explain how demographics, immigration, and labor force participation affect the rate and sustainability of economic growth.

Answer 7

Demographics: age, fertility

Immigration: can be used to overcome declining labor force

Labor Force Participation: labor force / working age population (16-64)

Question 8

Explain how investment in physical capital, human capital, and technological development affects economic growth.

Answer 8

Physical capital:

Human capital:

Technological development:

Question 9

Compare classical growth theory, neoclassical growth theory, and endogenous growth theory.

Answer 9

• Classical: technology progress leads to a temporary increase in standard of living, but population growth decreases wages
• Neoclassical: in the long run, total growth closely linked to growth in total factor productivity (or growth in technology)
• Endogenous: economy is perpretual motion machine. Diminishing returns do not exist, the social returns overcome the diminishing returns

Question 10

Explain and evaluate convergence hypotheses.

Answer 10

Explain:

1. Absolute Convergence: standard of living will converge as productivity differences diminish
2. Conditional Convergence: convergence only for countries with similar savings rates, population growth rates and production functions
3. Club Convergence: Countries belonging to a club will converge. Clubs are countries with similar institutional features.

Evaluate:

Question 11

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

Answer 11

Rationale:

• Social returns: External benefits to the economy of investing in R&D projects
• Private benefits may be insufficient to cover the required rate of return on some R&D spending
• When private benefits and social returns together exceed the required rate of return, government subsidides may provide incentives for investment R&D

Question 12

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

Answer 12

When you remove trade barriers, the impact on:

• Capital investment and profits: access to foreign savings
• Employment and wages: comparative advantage in production
• Economic growth: economies of scale