Economic Growth and the Investment Decision

• The sustainable rate of economic growth is measured by the rate of increase in the economy’s productive capacity or potential GDP.
• Growth in real GDP measures how rapidly the total economy is expanding.
• Per capita GDP, defined as real GDP divided by population, measures the standard of living in each country
• Higher sustainable economic growth should lead to higher earnings growth and equity market valuation ratios, all other things being equal.
• The best estimate for the long-term growth in earnings for a given country is the estimate of the growth rate in potential GDP
• In the long run, the growth rate of earnings cannot exceed the growth in potential GDP.
• Labor productivity is critical because it affects the level of the upper limit. A permanent increase in productivity growth will raise the upper limit on earnings growth and should translate into faster long-run earnings growth and a corresponding increase in stock price appreciation.
• For global fixed-income investors, a critical macroeconomic variable is the rate of inflation. 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, an increase in the capital-to-labor ratio, occurs when the growth rate of capital (net investment) exceeds the growth rate of labor.
• In a graph of output per capita versus the capital-to-labor ratio, capital deepening is reflected by a movement along the curve.
• An increase in total factor productivity (TFP) causes a proportional upward shift in the entire production function.
• One method of measuring sustainable growth uses the production function and the growth accounting framework developed by Solow. It arrives at the growth rate of potential GDP by estimating the growth rates of the economy’s capital and labor inputs plus an estimate of total factor productivity.
• A method of measuring sustainable growth measures potential growth as the long-term growth rate of the labor force plus the long-term growth rate of labor productivity.
• 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.
• The labor supply is determined by population growth, the labor force participation rate, and net immigration.
• Technological advances are discoveries that make it possible to produce more or higher- quality goods and services with the same resources or inputs.
• Technology is a major factor determining total factor productivity.
• Total factor productivity, estimated using a growth accounting equation, is the residual component of growth once the weighted contributions of all explicit factors (e.g., labor and capital) are accounted for.
• Labor productivity is defined as output per worker or per hour worked.
• Growth in labor productivity depends on capital deepening and technological progress.
• The academic growth literature is divided into three theories—the classical view, the neoclassical model, and the new endogenous growth view.
• In the classical model, growth in per capita income is only temporary because an exploding population with limited resources brings per capita income growth to an end.
• In the neoclassical model, a sustained increase in investment increases the economy’s growth rate only in the short run.
• The neoclassical model assumes that the production function exhibits diminishing marginal productivity with respect to any individual input.
• The main criticism of the neoclassical model is that it provides no quantifiable prediction of the rate or form of TFP change. TFP progress is regarded as exogenous to the model.
• Endogenous growth theory explains technological progress within the model rather than treating it as exogenous. As a result, 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, where increasing capital will result in diminishing marginal returns, the endogenous growth model allows for the possibility of constant or even increasing returns to capital in the aggregate economy.
• 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.
• Total factor productivity is the main factor affecting long-term, sustainable economic growth rates in developed countries and also includes the cumulative effects of scientific advances, applied research and development, improvements in management methods, and ways of organizing production that raise the productive capacity of factories and offices.
• Capital is subject to diminishing marginal returns, so long-run growth depends solely on population growth, progress in TFP, and labor’s share of income.