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LM02 Economic Growth and the Investment Decision 2023 Level II Notes © IFT. All rights reserved 1 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 reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are
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LM02 Economic Growth and the Investment Decision 2023 Level II Notes © IFT. All rights reserved 3 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- 1980 1981 - 1990 1991 - 2000 2001 - 2010 1950 1970 1990 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)
LM02 Economic Growth and the Investment Decision 2023 Level II Notes © IFT. All rights reserved 4 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