Learning Module 2: Economic Growth

Learning Module 2 Economic Growth EXAMPLE 1 Why Growth Rates Matter In 1950, Argentina and Venezuela were relatively wealthy countries with per capita GDP levels of $6,164 and $8,104, respectively. Per capita GDPs in these Latin American countries were well above those of Lapan. South Korea, and Singapore, which had per capita GDPs of $3,048, $1,185, and $4,299, respectively. By 2018, however, a dramatic change occurred in the relative GDPs per capita of these countries. Real GDP Per Capita in US Dollars 1. Calculate the annual growth rate in per capita GDP for each of the five countries over the period 1950-2018 Solution The annual growth rates for the five countries are calculated as follows: Argentina [($18.255/56.164)/68-11.6% Venezuela ($9,487/88,104)106-1-0.2% Japan [($39,313/$3,048)-13.8% Singapore [($66.189/84,299) 0-1-4.6% South Korea [($36,756/S1.185)-1-5.2% 2. Explain the implication of the growth rates for these countries. Solution Differences in GDP growth rates sustained over a number of decades will significantly alter the relative incomes of countries. Nations that experi- ence sustained periods of high growth will eventually become high-income countries and move up the income ladder. In contrast, countries with slow growth will experience relative declines in living standards. This dynamic is well illustrated in this example by a historical comparison of growth in Argentina and Venezuela with Japan, Singapore, and South Korea. In 1950, Argentina and Venezuela were relatively wealthy countries with per capita GDP levels well above those of Japan, South Korea, and Singapore. Over the next 60 years, however, the rate of growth in per capita GDP was signifi cantly slower in Venezuela and Argentina in comparison to the three Asian countries. This disparity resulted in a dramatic change in these countries relative incomes. The per capita GDP of the three Asian countries rose sharply as each joined the ranks of developed countries. In contrast, Argentina and Venezuela stagnated and moved from the ranks of developed coun- tries to developing country status. By 2018, per capita income in Singapore was more than seven times higher than in Venezuela. Over the long run, the economic growth rate is an extremely important variable. Even sumall differences in growth rates matter because of the power of compounding. Thus, policy actions that affect the long-term growth rate even by a small amount will have a major economic impact. 3. Suppose that GDP per capita in Argentina had grown at the same rate as in Japan from 1950 to 2018. How much larger would real per capita GDP have been in Argentina in 2018? Solution: Assurning Argentina had grown at the same rate as Japan since 1950, its GDP per capita in 2018 would have been (56,164)(10.038)- ($6,164) (12.63)-$77,854, versus $18,255 from Exhibit 1. If Argentina had grown at the same rate as Japan, it would have had one of the highest standards of living in the world in 2018. The question is why the growth rates in Argentina and Venezuela diverged so much from the three Asian countries 4. Venezuela plans to stimulate growth in its economy by substantially increas ing spending on infrastructure, education, and health care. Nevertheless, foreign investment is discouraged, and reforms such as strengthening the legal system and encouraging private ownership have been largely ignored. Explain whether the measures described here could lead to faster economic growth. Solution The preconditions for economic growth are well-functioning financial markets, clearly defined property rights and rule of law, open internation- al trade and flows of capital, an educated and healthy population, and tax and regulatory policies that encourage entrepreneurship. Investment in infrastructure would increase Venezuela's stock of physical capital, which would raise labor productivity and growth. Better education and health care would increase human capital and also increase productivity and growth. These measures would raise Venezuela's growth prospects. Missing, how ever, are a legal system that could better enforce property rights, openness to international trade and foreign investment, and well-functioning capital markets. Without changes in these preconditions, a significant improvement in Venezuela's growth is unlikely to occur. The following table summarizes these preconditions: Preconditions for Growth Impact of Planned Policy Action in Venezuela Saving and investment - Improve growth potential Developed financial markets- No impact Legal systems- No impact Property rights and political stability- No impact Education and health - Improve growth potential Tax and regulatory policies discouraging entrepreneurship - No impact Preconditions for Growth Restrictions on international trade and flows of capital Impact of Planned Policy Action in Venezuela - No impact It should be noted that the global economy is evolving rapidly and past trends may or may not be sustained. Nonetheless, in order to provide concrete answers that do not require the reader to bring in additional information, our exercise solutions must assume past patterns are indicative of the future. EXAMPLE 2 Impact on Equity and Fixed Income Investors Your firm subscribes to asset-class risk and return estimates generated by a vendor. The equity market return estimates are based primarily on long-term average index returns. Following a multi-year period of very high equity returns driven by unusually high earnings growth and expanding P/E multiples, capital's share of total income as well as valuation multiples are near all-time highs. Based on the latest data, the vendor projects that over the long run, your domestic equity market will return 13.5% per year-11% annual appreciation and 2.5% dividend yield forever. Your firm also subscribes to a macroeconomic forecasting service that provides, in addition to shorter-term projections, estimates of the long-term growth rate of potential GDP and the long-term inflation rate. This service forecasts 3.25% real growth in the future and 3.75% inflation, down from 4.0% and 5.0%, respectively, over the last 75 years. 1. Why might you have greater confidence in the macroeconomic service's forecasts than in the vendor's equity market return forecast? Solution High volatility makes equity returns very hard to predict based on their own history. Extrapolating historical equity returns does not factor in changes in economic conditions, valuation changes, and the potential for economic growth. Long-term real GDP growth rates tend to be far less volatile, especially for developed economies such as the United States or the euro area, because long-term potential growth is driven by slowly evolving fundamental economic fortes. Similarly, for countries with prudent monetary policies, inflation rates are much less volatile than stock prices. Thus, one could reasonably place much higher confidence in forecasts of long-term real and nominal (real growth plus inflation) GDP growth than in equity market return forecasts based on historical equity returns. 2. Assuming the macroeconomic forecasts are accurate, what implicit assumptions underlie the vendor's forecast of 11% equity market appreciation? Solution Using the Grinold-Kroner framework, equity market returns can be attributed to (1) dividend yield, (2) expansion/contraction of the price-to-earnings ratio, (3) nominal GDP growth, and (4) change in shares outstanding. The macroeconomic forecast indicates that nominal GDP will grow at 7% (3.25% real 3.75% inflation). So, the vendor's forecast of 11% equity market appreciation implies a 4% annual combined contribution from expansion in the P/E multiple and/or change in shares outstanding of GDP over the long run an assumption that cannot hold. 1. Assuming the macroeconomic forecasts are accurate, what would be a more reasonable forecast for long-term equity returns? Solution Neither the P/E nor the profit share of GDP can grow at a high rate forever A much more reasonable forecast of long-term equity market returns as would be the projected 7% growth rate of nominal GDP plus the 2.5% dividend yield. A projected equity return of 9.5% over the long run is much more reasonable, subject to variability in dividend yields and price-to-earnings ratios. 4. In addition to its long-term potential GDP forecast, the macroeconomic forecasting service estimates sluggish 1.5% GDP growth for the next year Based on this short-term GDP forecast, the bond analyst at your firm recommends that the firm increase its fixed-income investments. What assumptions underlie the hond analyst's forecast? Solution With forecasted actual GDP growth well below the growth in potential GDP, the bond analyst assumes a growing output gap or slack in the economy (Le., there may be a slowdown in the economic cycle). This slack may place downward pressure on inflation and reduce inflationary expectations. To close this gap, the central bank may need to lower short-term interest rates and ease policy. In such an environment, bond prices should rise. EXAMPLE 3 Capital Deepening vs. Technological Progress One of main differences between developed and developing countries is the amount of capital available for each worker. Country A is an advanced economy with $100,000 of capital available for each worker and, thus a high capital-to-labor ratio. In contrast, Country B is a developing country with only $5,000 of capital available for each worker. What impact will the following developments have on the growth rate of potential GDP? 1. An increase in business investment in both countries Solution An increase in business investment will raise the capital-to-labor ratio in both countries. It results in capital deepening and a movement along the per worker production function. The impact on growth, however, will be completely different for the two countries. Country B will experience an increase signifi- in output per worker and thus in the growth rate of potential GDP. This is because Country B operates at a low level of capital per worker, at a point like A in Exhibit 3. Diminishing returns to capital are small, so any addition to capital has a major impact on growth. Country A operates at a point like B in Exhibit 3, so additions to capital have little impact on growth because of diminishing returns. 2. An increase in the amount of spending on university research in both countries Solution An increase in spending on university research will increase TFP and cause an upward shift in the production function in both countries. This can be seen in the move from point B to point C in Exhibit 3. The shift in the production function will raise growth in both countries and offset the negative impact of diminishing returns. This result shows that developing countries have the potential to grow through both capital deepening and technological progress, whereas improvement in potential GDP growth in developed countries is largely driven by technological progress. 3. An elimination of restrictions in Country B on the inflow of foreign investment Solution The elimination of restrictions will result in higher foreign investment, which has the same impact as an increase in domestic business investment. This is again a movement along the production function such as from point A to B in Exhibit 3. With diminishing returns insignificant at low levels of capital to labor, the higher level of foreign investment will boost growth of potential GDP in Country B. EXAMPLE 5 Impact of the Age Distribution on Growth: Mexico vs. Germany Exhibits 4 and Exhibit 5 provide population data for selected countries. The data show that the rate of population growth and the age composition vary significantly among countries. Thus, demographic factors can be expected to have a significant impact on relative growth rates across countries. This effect is very clear in the cases of Mexico and Germany. There was essentially zero growth in Germany's population from 2000 to 2018, while Mexico's population increased by 1.35% annually. The age composition of the two countries is also very different. 1. How will the age distribution impact growth over the next decade? Solution What is important for growth is the number of workers available to enter the workforce. Over the next decade, Mexico will receive a demographic benefit because of the high percentage of young people entering the workforce. This is because 26.5% of the population in 2018 was below the age of 15. In contrast, only 13.5% of the German population was below the age of 15. In addition, Germany is facing a demographic challenge given the high and growing share of its population over the age of 65. In Mexico, only 7.2% of the population is above the age of 65, compared with 21.5% in Germany. In sum, the lack of population growth and a rapidly aging population in Germany will limit its potential rate of growth. Germany must rely on high labor productivity growth, increase its workforce participation rate, or encourage immigration if it is to increase its near-term potential rate of growth. Meanwhile, potential GDP growth in Mexico should receive a boost from its favorable population trends. EXAMPLE 7 Why is there sluggish growth in the Japanese economy? Annual growth in real GDP in Japan averaged about 1% since 1990. This growth is in sharp contrast to the 4.2% annual growth rate experienced from 1971 to 1990. The sluggish growth in Japan should not be surprising. Japan's economy is growing at its potential rate of growth, which is limited by the following: 1. The labor input is not growing. Population growth has been essentially zero since 2000 (Exhibit 5), and average hours worked per year per person is declining (Exhibit 8). 2. There has been a lack of technological innovation. The lack of growth in the labor input could be offset through higher productivity derived from innovation and more efficient use of available inputs. However, this is not occurring in Japan. Total factor productivity (Exhibit 10) increased at a sluggish 0.4% annual rate from 1995 to 2005 and declined slightly between 2005 and 2018. 3. Diminishing returns to capital are very significant. Despite the neg- ative growth in TFP, labor productivity growth remained relatively high. This means that all the growth in labor productivity in Japan resulted from capital deepening (Exhibit 10). The problem for Japan, as discussed in earlier, is that once the capital-to-labor ratio becomes high, further additions to capital have little impact on per capita output. Thus, the growth in labor productivity should slow. 1. Use the data for 2005-2018 and the labor productivity growth accounting equation to estimate the growth rate in potential GDP for Japan. Solution To estimate the growth rate in potential GDP, we use Equation 5, given by Growth rate of potential GDP Long-term growth rate of labor force + Long-term growth rate in labor productivity To use this equation, we need to project the growth rate in the labor input and labor productivity. The hours worked data in Exhibit 10 are a potential source to use to estimate the growth rate of the labor input. Exhibit 10 shows the labor input for Japan remained unchanged between 2005 and 2018. This was partly caused by the negative impact of the global recession on hours worked. As an alternative, the labor input should grow at the same rate as the population plus the net change in immigration. The population data in Exhibit 5 show essentially zero population growth in Japan for the period 2000-2018. This trend is likely to continue. Thus, a reasonable estimate for potential GDP growth in Japan is around 1%. We get this estimate by assuming no growth in the labor input and a 1% annual increase in labor productivity (using data from Exhibit 10 for 2005-2018). EXAMPLE 13 The Entry of China and India into the Global Economy China and India effectively entered the global economy in the 1980s as they shifted toward more market-oriented policies and opened up to global trade. Their impact on global growth was significant. In 2018, according to the IMF. China and India accounted for 20% and 8% of world GDP (based on PPP), respectively, whereas the two countries combined for only 4.2% of global output in 1980. The entry of these two countries significantly increased the global supply of skilled and unskilled labor receiving relatively lower wages. As a result of the surge in available labor, global potential GDP increased sharply. Economic theory suggests that the supply-side increase in the global capacity to produce goods and services would increase global output and put downward pressure on prices. The neoclassical model of growth can provide us with some further insights into the impact of China and India entering the global economy. At the time, China and India had relatively lower wages and capital compared with the United States and Europe. One would expect that the rate of return on capital would be higher in China and India and that capital would flow from the developed countries to China and India. Hence, both China and India would be expected to run trade deficits. This has been the case for India but, contrary to the model's prediction, China has run trade surpluses. These surpluses stem mainly from China's very high domestic saving rate. Nonetheless, China has experienced large foreign direct investment (see Exhibit 18) inflows, which have reinforced its already high private investment rate. As China and India accumulate capital, their capital-to-labor ratios, real wage levels, and per capita income should converge toward those of the advanced economies. Depending on global aggregate demand conditions, wages might even have to fall in the developed countries in the process of shifting wealth and income to the developing economies. Because of the surge in the global supply of labor, the overall share of labor in global income should decline relative to capital. In addition, global productivity should rise as China and India account for a rising share of global output. In sum, over the long run, the growing share of global GDP going to China and India will benefit the global economy as more efficient utilization of resources allows global potential GDP to grow more rapidly for an extended period. EXAMPLE 14 Why Some Countries Converge and Others Do Not As evident from the high rates of growth between 1950 and 2018 shown in Exhibit 18, China and South Korea are converging toward the income levels of the advanced economies. In contrast, the economies of Mexico and South Africa have not converged. 1. Using the data in Exhibit 18, give some reasons why this has occurred. Solution Two reasons largely account for the difference. First, growth in the Chinese and South Korean economies has been driven by high rates of business investment. As shown in Exhibit 9, investment as a share of GDP in 2018 was 44% in China, almost double the rate of 23.0% in Mexico and more than double the rate of 18% in South Africa. Although investment as a share of GDP in South Korea is lower than in China, it is well above that of Mexico and South Africa. Second, both China and South Korea have pursued an aggressive export-driven, outward-oriented policy focusing on manufactured goods, In 2018, exports were 44% of GDP for South Korea and 19.5% of GDP for China (Exhibit 18). In addition, foreign direct investment is a major factor underlying growth in China. On the other hand, South Africa's more inward-oriented economy attracted only $5.3 billion in foreign direct investment in 2018, significantly less than that of Ireland-a smaller but much wealthier and very open country-and the $203 billion inflow of foreign investment into China. These trends are changing, however, as many African and Latin American countries are increasingly relying on growing exports and foreign investment to increase GDP growth.