Economic Growth and Sustainability: An Overview | CFA Level I Economics

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

We’re now shifting our focus from the short-run cyclical movement of the economy to its long-term growth and sustainability.

Five Important Sources of Economic Growth

Economic growth can be best explained by examining these five important sources:

• Labor supply: The number of people over the age of 16 who are either working or looking for work. It is affected by population growth, immigration, and the labor force participation rate. The growth of the labor force is an essential source of economic growth.
• Physical capital stock: Plant and equipment built up over the years to produce goods and services. Investments by businesses increase a country’s stock of physical capital. Countries with a higher rate of investment into productive physical capital usually have a higher rate of GDP growth.
• Human capital: The education and skill level of a country’s labor force. Economies with skilled and well-educated workers are more productive as they can better harness advances in technology. This is why many countries invest in human capital either through education or importing talent from overseas.
• Technology: For most developed countries, the most important source of economic growth. As there are diminishing marginal productivity in adding physical capital, technological advances are essential as they allow advanced economies to overcome such limits. Improvements to productivity through technology require investments in more advanced equipment and software that can produce more efficiently, and a skilled workforce that can develop and harness the benefits of technology. Countries typically innovate through expenditures on R&D.
• Natural resources: Raw material inputs, such as oil and land, necessary to produce economic output. These resources may be renewable, like forests, or non-renewable, like oil. Countries with large amounts of productive natural resources like oil can achieve greater rates of economic growth. However, natural resources are not necessary for economic growth, as evident in economies like Japan and South Korea, which have achieved massive economic growth with little natural resources. In fact, natural resources are not considered in some economists’ models of GDP.

The Production Function and Labor Productivity

One common model is to define the aggregate economic output of an economy as a function of the size of the labor force (L) and the amount of capital available (K). The human capital aspect is captured inside the function.

Total factor productivity (A), a proxy for technology, is a multiplier to this function. It cannot be observed directly and must be inferred based on the other factors. This relationship is known as the production function.

Aggregate output (Y) = A x f(L,K)

The production function can also be stated on a per-worker basis by dividing by L. The output per worker, a measure of labor productivity, is the total factor productivity multiplied by a function of physical capital per worker. This relationship suggests that labor productivity can be increased by either improving technology or investing in more physical capital per worker.

Economists often look at labor productivity as a measure of the health and prosperity of an economy. The higher the level of labor productivity, the more goods and services the economy can produce with the same number of workers.

In fact, labor productivity is one of the two key determinants of the growth in potential GDP of an economy. Potential GDP can be stated in terms of the size of the labor force times labor productivity or as the aggregate hours worked times labor productivity.

When stated in terms of growth, the growth in potential GDP of an economy boils down to the growth in the labor force plus the growth in labor productivity. An economy’s long-term sustainable growth rate can be estimated by estimating the long-term growth rate of the labor force and the long-term growth rate of labor productivity. For example, if Japan’s labor force is projected to shrink by 1% in the long-term, while its labor productivity is expected to grow by 2.5%, then we would estimate the long-term growth in potential GDP as 1.5% per year.

The long-term sustainable rate of economic growth is essential because long-term equity returns are highly dependent on economic growth over time.

The Solow Model and Growth Accounting

Another well-known model of expressing economic growth is the Solow model or neoclassical model. The growth in potential GDP equates to growth in technology, plus the growth in labor, plus growth in capital.

The weights, W_L and W_C, are labor’s percentage share of national income and capital’s percentage share of national income, and they should add up to 1. The assumption here is that the contribution of labor and capital to long-term growth depends on their respective shares of national income. For most developed economies, W_C is lower than W_L, so according to this model, investments in physical capital to grow the economy are less effective than growing the workforce.

Like the multiplier A in a production function, the “growth in technology” represents the change in total factor productivity. This is the growth of output that is not explained by the growth of labor and capital. Growth in technology is the primary driver of the growth in total factor productivity.

Growth in Per Capita GDP

The growth accounting equation can be further modified to explain growth in per capita GDP.

For example, if W_C is 0.3, each 1% increase in capital per worker will increase GDP per worker by only 0.3%. In developed economies where capital per worker is already relatively high, there may be diminishing marginal productivity of capital. This means that policymakers cannot continue to grow the economy through capital deepening investments—that is to say, increasing physical capital per worker over time. Sooner or later, economies have to turn to growth in technology as the primary source of growth in GDP per worker.