Reading 6: Economic Growth and The Investment Decision

Page No. 15313th Friday 2022Date / /Reading 6 : Economic GrowthAnd The Investment DecisionConditions Suitable for GrowthKey Requirements for growth0Savings and investmentHigh savingsHigh lvl of invest"High GDP growthPoolActAllocating CapitalFinancial markets & intermediaries Design product & ServicesFinancial sector channel saving to projects that offer highestrisk - adj returnsFinancial sector channels enchorage savings by creating financialinstrument that facilitate risk transfer and enchance qualityAggregating small amt of saving into a larger pool enablesintermediaries to finance larger projects3Political stability t rule of law & property rightsCountries that have stable and effective goverment 4 welldeveloped legal, regulatory & property rights systems haveFactor such as wars , corruption & political instability raisehigher economic growth.invest risk & weaknen eco growth. Page No. 154Date//Invest" in human Capital4Education & Healthcare systemsBasiceducation raises the skill lul of the workforce whichcontributes to potential economic growthEducation Can also raise growth by increasesing the productivityof existing physical capital.Empirical studies show that poor health has results in slowingdown of economic growth5Tax & regulatory SystemsLimited regulationsMore growth & productivity6Free trade and unrestricted Capital flows :Foreign investments breaks out the cycle of low incomes,low saving & low investIt domestic can be direct (FDI) or indirect (buying equity / debt issued byCompanies)Free trade at benefits a countries economy by providing moregoods lower costsRelationship bet Stock market Appriciation & Sustainablegrowth rate of EconomyGrowth in aggregate stock market valuation is afunction ofIGDP growth2Growth in earnings relative to GDP3Growth in PLE ratio Page No. ISSDate//P (GDP)=XCE/GOP)XPE)%DP = GDP + % A E/GDP) + %D (PLE)3fuctorAggregate priceAggregate earningsof equitieswill be zero in the long term as :-labourwillbe unwilling to acceptevershare of GDPInvestorswillnotContinuetopayaneverprice forsamelvlofearningsforever.i. DP 11 AGDP Iinthe long runIn the long fun :-%ALE / GDP) = % ACPIE) = 0Growth in equity price = GDP growth rateNote :Over the short and medium term all three factors contributesto Increase / decrease in stock market but in the long-termgrowth late of GDPdominates(E/GDP) & (PLE) can't rise forever or can't decline foreeverOver the long-term (EIGDP) & (PIE) will be zero Therefore Page No. (56Date//Potential GDPHigher Potential GDPConsumers expect income to riseHigher real int ratesThey increase current consumption &to encourage SavingSave lessHigher the potential GDP growth rate + higher the real rates(int and asset returns).Implications for fixed - income investors:policy is restrictivepressure is higher RT and Bond more likely that monetary I fiscalWhen actual GDP growth > potential GDP growth rate, inflationayHigher potential GDP growth rate reduces expected credit riskof all debt issuesCorpmunia palNote:-soveiignOver heated ecoActualGDPnominal int rate Crestrictive monetary policy) and fiscal surplus.> Potential GDP = Inflationary gap This results in higherHigher potential securities GDP growth rate improves credit quality of fixedincomeHigher potential GDP growth rate reduces expected credit risk.REK,L %10Saving4 = 2(107.) + (1107= 10% CapitalrelativetoIFcostd= ofPage No.157letaDate//thegrowthInGDPFutureincomeexpectedtoriseSavelessforfutureConsumerscurrentconsumptionConsumptioninvest"wouldLFofferahighertoencouragesavingsrate of returns.Potential&interestLGDP growthHigherassetratereturn*CapitalDeepeningandTechnologicalupprogressCobbOutput($) Realterms Not nominal-Douglasproductionfunction= TK d(1-2)there&=ShareofoutputallocatedtolabouraswellascapitalT= TotalTechfactorproductivityLabourk = Capital2 and(1-d)arethesharesofoutputallocatedtoCapital(k) andlabor(L):2L1107 TK40107Cobb-Douglasfunction:DiminishingmarginalproductivityoflabourandCapitalbutconstantreturntoscale107.LT44(1-d)10%/steadystate+marginalproductofCapital(MPK)=rentalpriceofCapital(1):LYLKr Page No.158Date / /This function exhibits Constant returns to scaleOutput per = Labour= 1=T(x)workerproductivityLAssuming the no. of workers & & remainConstant ,inoutput Can be gained byCapital per worker(capital deepening) or by improving technologyLower the value of d, + lower thebenefit of Capital deependingDeveloped markets typically have a lowerxasComparedto developing marketsMPKIn equilibrium t the marginal product of Capital & marginalcostofCapital are equal Ahave& 4 =rrkkRental priceofr = rate of returnCapitalK = amount of Capitalrk=amountofreturntoprovides of capitalrk = amountofoutputallocated totheprovidesof4CapiLabour productivity =Growth due togrowth ratesTechnology+changeCapital deepening Aduntage - No need to est capital input and compute TFPmatvantay e- Capital deepening and TFP progress can Bage No. 159difficulttoanalyzeandpredictoverlong-term Date/AbsoluteRelative(1-d)= TKLknown as growth accounting equation%.AY=%=ATFPtdx%DLFEconomies willincreaseaslongasMPK > rHigher 2 suggestshigherimportanceforcapitalfordevelopingMPX Marginal Product ofProductivityCurveandEconomicGrowthCarl=Capit ful4labor productivityDM&P=Dimieishing =Marginal productivi(fool GDP per workero(shift)More techMPKSMPXBLess technologyd=k++Ecoslope= IP MRPXBGrowthAMPK=rxEffect of capital deepening-dBMPK.>(but note diminishingLA SOLBreturns )Co CapitalGEmergingdeveloped Capital per L(7)ProductivitydeepingCurveGraphoflaborproductivityVScapitalperworkerforgivenlvloftechnology0Twosourcesofeconomicgrowth(growthinlabor productivity ):talIGrowthincapitalperwork-Capitaldeepening(movementalongtheproductivity curve)2Technological change (growth in total factor productivity) Shift inproductivity luleSteepe Page No. 160Date//Capital DeepeingH is an increase in capital - to - labor ratioIt is the movement along the productivity curveOnce capital - to -labor ratio becomes very high . father additionto capital have relatively less impact on GDP (diminishingmarginal productivityTechnologycial progress enhances the productivity of both capitaland laborALong-term 0 growth rate Can be increased by technological progressTechnological progress will cause shift in productivity curveGrowth Accounting RelationshipCobb Douglas :- Y = TKa d (1-2)Growth rate in = Long term growth rate of technologyPotential GDP+2 Clong term growth rate of Capital)+(1-d) (long term growth rate of labor )= Long term growth rate of labor force andlabor productivityforGrowth rate in = AY = ATt&AK+ (1-d) ALpotential GDPYTKelasticities Page No. (6)TFP = Total factor of ProductivityDate / /The labor productivity growth accounting equation :-Growth rate in potential GDP = long-term growth rate of labor force+ long-term growth rate in labor productivityAY =AL+EverythingYelseIncludes capital deepening andchanges in total factor productivityExample :-Following information is available for Azikland :VariableLong -term ForecastLabor force growth rate1.5% L60% 2 =40lost of labor factor cost =3% = AKGrowth rate of CapitalATGrowth of total factor productivity27.CalculatethegrowthrateinpotentialGDP501" n Growth rate ofATtofAK + (1-d)ALpotential GDPTK=2% + ( 0.4 x37.) + (0.6x 1.5%)= 4.1% Page No 162low ownershipDate//poor endownmentlalgehigh ownershipImpact of Natural ResourcesOwnership of natural resources is not important as longas there is access (via trade).Ownership of natural resources may actually hinder growthIPutch disease :Ownership of natural resources pushes up thePValue of domestic currency to the determint of otherindustries.[2Other industries may be neglected0demand for natural resorse the currency's value &3makes the exports more expensive ; thus rendering thedomestic industries uncompetivitie in the market.Labor Supply FactorsIDemographics :Population growth is determined by fertility ratesand mortalility rates.DPopulation growth may increase growth rate of the overall economybut it has no impact on the rate of increase in perCapital GDPAgeing of population PageNo. 163Date//2Labor force participation :-0 Labor force participation rate = Labor forceWorking age populationIncrease in this rate may increase per capita GOP3 Immigration:-DIt is a possible sol" to declining labor force growth whichis experienced by developed countries with low birthratesCan be used to overcome declining labor force4Avg hours worked :-DCultural factors, , labor regulation & taxation0Highly sentivity to biz cycleALong - term trend in avg hr worked is downwards0Causes of this development : Legislation growth of part -time &temporary work, wealth effect etc.Capital and TechnologyHuman Capital : Qualitative measures of knowledge and SkillsPhysical Capital: ICT Cinfra computers & telco equipment) non-ICT -Invest" in physical Capital 2 Growth Networking effectTFPTechnological develoment - Inducles invest" In physical & human capitalPublic Infra - provide additional benefit to private investNotes:-here is higher correlation b/w invest" in physiad & humanCapital & eco growth Page No. 164Date //Introduction of tech results in an upward shift in theproduction functionImprovements in infra generally boosts the productivity ofprivate investGrowth TheoriesThree growth theories :-P1Classical Growth Theory2Neoclassical Growth TheoryI3Endogenous growth Theory0Be able to distinguish major tenetsFocus on the big pictureI] Classical Growth Theory old (Temporary)(Main point :- No permanent improvement in standard of livingfrom new techoSubsistence Real wageTechnological advancelead tomin wage to support lifeIShort-term economic growth2Temporary improvement of standard of living stustainesReversing mechanism is population growth- Eco growth leads to population growthCycleTemporarypopulat exploringscench Page No. 165Date / /LP,More techLP.Less techsubsistencedaphwageaCoCapital per workkey assumption: Population growth accelerates when the lulof per capita income rise above the substence lulPopulation growth is reversing mechinsmTechnological progress & land expansion Increase in labor productivityHigher population growth.In the long run, adoption of new technology results in largerbut not richer population.H was labeled 'Dismal science'Growth is temporaryIIIMP Neoclassical Growth Theory (Technology)LuckMain point :- Economic growth results for lucky discoveriesof new technologiesTech is exogeneousMajor diff with classical theory :-- Eco growth is independent of population growth Cobb - Douglas P.F4 = A . F(K,L)1.14 =TFP 7 LAK +(1-d) ALPage No. 166Total output (4) =100TFP Capital TabulDate / /(601) 60 provided(407.190 byTech advances lead to: by capitalLabor2I Short - term economic growth Steady state MPK (per Capital)PermanentlyhigherlivingstandardBothcapitalandlaborarevariablesinputsandsubjectsdiminishing murginal productivityTechTPADGrowth rate of output per Capita : of =TFPgoathsSustanable1-d1-0laborAGrowth rate of output :G=AL= g+ALSubstable growth rate 1-2+= TFP +AL0I -aDCapital deepening the has no state effects on growth rate or MPKoncesteadyisreachedpoutput to Capital ratioLP2-MPK crental priceMore techConstant (steady state)LP,=Capital deepening wantsticeMPK > SentalU.=Less techHigher savingHigher CapitoBJapanWont be usefulAtoCcapital Per workIn steady state T growth rate in productivity depends only ontech & (1-d)Major tent :- accumulation1Capital dee peing occurs affecting output but not therateunitwereachgrowthsteadystate Page No. 167Date//Marginal product of capital = MPK2regardless of initial capital to labor ratio K of to ofEconomy will move towards its steady state equilibrium leveltechMPK = 5has3Cover new workers and Capital dep (capital per worker constant)Steady state savings & investment are just sufficcient to4Developing countries (with low capital to labor) would havelowerdiminishing marginal productivity of capitalDevelovedRealEndogenous Growth Theory (Tech withinint Rate & Creation of knowledge CapitalGreedythe modelDevelopingMain point ; Economy is perpetual motion machinewhy No Stopping mechanismBuild intoTH=F(KLL)- Technological progress in endogenous the modeMorePhilosophy14Growth in stundar of livingLoganLess Technological growthLestCapital deepeniryCapital deepeinscapital l labor hrAssumption : Constant returns to capitalTechnological progress is treated endogenous Coming from within)Eco does not necessarily converge to a steady stategrowth rate.Increase in Saving permaently increase S growth rate Provide soln to increase TPPspend on R&D and human capitalPage No. 168Highes savingwill helpDate//Human capital and R&D spending are factors of productionjust like capital andlaborSpending on human Capital & R&D generates benefits to+eco as a whole Creation of knowlege Capital & Real int ruteEndugenous Vs Neo dassicalProductivity growthNeoclassical,Innovationlacks this stepMPKSAHigher profitsSocial ReturnsMore investDConvergence HypothesisCapital deepeningof\Absolute Convergence :- Developing Country will match developed per Capita outputCountriesStandard of living will converge globally as productivity dg)betn developed and developing Countries diminish over timeless developed Countries will achieve equal living stand over timeImplies on Capital growth rate not non per capital incomeNC assume treat all Countries have same tech - growth inyl will equal Not2Conditional Convergence :-LevelConvergence only for countries with similar saving rates,population growth rates & production functions (Memorize this)Implies on per capita out as well as steady rate growth rateDeveloped 3 Standard. living ofDeveloping Page No. 169Date//3Countries belonging to a club will converge Clubs are countriesClub Convergence :-will similar institutional featuresclab (having similar institutional structer) are convergingOnly rich & middel - income are to the ofcountries that membersrichest countries in the world.0Countries with the lowest per capita income in the dubgrow at the fastest ratePoorcountries can join the club if they make appropriate notinstitutional change This explains why some countrie s that haveimplemented appropriate eco reforms by behindIncentives to private InvestingSocialreturn: External benefits to the economy of Investingin R&D projectsPrivate benefits may be in sufficient to cover the req rateon some R&D projects.When private benefits and social returns togther exceed thereq rate of return, govtSubsidies may provides incentivityfor investment in R&D.tax breaksEndo theoryUnder endogenous growth theory private Sector invest in R&Dand human capital benefits the society overall.Govt incentives can increase private sectors invest" in R&D ,which can lead to overall growth in the economy. Page No. 170Date//Removal of trade BarriersRemoval of trade barriers benefits growth via :I Access to foreign Saving2Comparative advantage in production3Eco. of scalesAs per neo classical growth theory :-ConvergenceAConvergence will be more quick if eco are open &is free trade. Developing Countries can grow more rapidlyOif there is free trade & unrestricted CapitalIAs per endogenous growth theory :-social benefitsMore open trade will permanently increase growth rate.International trade increase global output through selection effect,survival ofScale bitteseff & backwardness effectforeign CoSelection effet :Competition form fotex Countryless efficient Los exitsmore efficient will inovateScale effect : producer exploit eco of scaleBackwardness effect less advanced countries or sector, of an eco cetchingup with more developed country or sector throughKnowledge spillover Page No. 171Date//Capital = Growth rate of labor Productivity -TFPdeepeing=the diff more capital deepingthere