Home › CFA® Level II › Economics
CFA® Level II · Economics · free lesson
Economic Growth
Long-run growth of potential GDP shapes corporate earnings, real interest rates, sovereign credit quality and the case for allocating capital across countries. This module compares growth in developed and developing economies, links potential growth to equity and bond markets, applies growth accounting to measure and forecast potential GDP, contrasts the classical, neoclassical and endogenous growth theories and the convergence evidence, and assesses how resources, demographics, trade and innovation policy affect growth.
What you will learn
1. Compare the drivers of and constraints on growth in developed and developing economies.
- Potential GDP growth drives long-run incomes, earnings and fiscal capacity.
- Growth differences compound: 2% doubles income in about 35 years, 6% in about 12.
- Preconditions: saving and investment, financial intermediation, rule of law and property rights, education and health, sound tax and regulation, openness.
- Developing economies can grow fast by adding capital and copying technology but face institutional constraints.
- Developed economies rely on innovation and face diminishing returns to capital and ageing.
2. Relate long-run equity market returns and bond market conditions to an economy's sustainable growth rate and potential GDP.
- Equity value = GDP x (E/GDP) x (P/E); growth is about nominal GDP growth plus changes in the profit share and the P/E.
- In the long run, aggregate equity value grows with nominal potential GDP; add the dividend yield for total return.
- Fast GDP growth does not guarantee high returns to existing shareholders (prices, dilution, foreign profits).
- Higher potential growth tends to mean higher real interest rates and better sovereign credit quality.
- Actual GDP above potential signals inflation pressure and tighter policy; below potential, the reverse.
3. Use growth accounting to separate the contributions of capital deepening, labour and technology, and forecast potential GDP.
- Y = A K^alpha L^(1 - alpha); alpha is capital's share; diminishing returns to capital.
- Output growth = TFP growth + alpha x capital growth + (1 - alpha) x labour growth; TFP is the residual.
- Labour productivity growth = TFP growth + alpha x (capital growth - labour growth), the second term being capital deepening.
- Capital deepening cannot sustain per-worker growth indefinitely; TFP growth can.
- Potential GDP growth = labour input growth + labour productivity growth (simpler, less informative alternative).
4. Contrast classical, neoclassical and endogenous growth theories and evaluate the convergence hypotheses.
- Classical: income above subsistence raises population, returning income per person to subsistence.
- Neoclassical: diminishing returns lead to a steady state; per capita growth = theta/(1 - alpha), output growth = theta/(1 - alpha) + n.
- In the neoclassical model, saving raises the level, not the long-run growth rate, of income per person.
- Endogenous growth: R&D, human capital and spillovers can make growth permanently higher; no convergence is implied.
- Absolute convergence is unsupported; conditional and club convergence fit the evidence better.
5. Assess how natural resources, demographics, trade openness and policy incentives for innovation affect growth.
- Natural resources can hinder growth through Dutch disease (real appreciation squeezes tradables) and weaker institutions; good management avoids the curse.
- Ageing and a shrinking working-age population reduce labour input; immigration and participation can offset it.
- Each point of labour growth adds (1 - alpha) points to output growth in growth accounting.
- Trade openness supports specialisation, scale, technology transfer and competition, speeding convergence.
- Education, R&D incentives, intellectual property protection, competition and infrastructure raise TFP growth.
Module at a glance
- Potential GDP growth drives long-run earnings and incomes; preconditions such as institutions, finance and education determine how inputs are used.
- Equity value = GDP x (E/GDP) x (P/E); in the long run it grows with nominal potential GDP, but fast growth does not guarantee high returns.
- Higher potential growth tends to raise real interest rates and improve sovereign credit quality.
- Growth accounting: output growth = TFP + alpha x capital growth + (1 - alpha) x labour growth; capital deepening = alpha x (capital growth - labour growth).
- Neoclassical steady state: per worker growth = theta/(1 - alpha); saving changes the level, not the growth rate; endogenous growth allows permanent effects.
- Absolute convergence is not supported; conditional and club convergence fit the evidence.
- Dutch disease, ageing, trade openness and innovation policy all shift potential growth.
This free module has 5 lessons, 17 practice questions with full explanations.