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Introduction to Introduction to Sources of GrowthSources of Growth

OverviewJan Gottschalk

TAOLAM

This training material is the property of the IMF – Singapore Regional Training Institute (STI) and is intended for the use in STI courses. Any reuse requires the permission of the STI. This training activity is funded with grants from Japan.

I. A Simple Metaphor (to organize OverviewOverview

p p ( gour thinking on growth)

II. Growth Through InvestmentIII. Growth Accounting ApproachIV Recent IMF Research on GrowthIV. Recent IMF Research on Growth

Factors

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Achieving MiddleAchieving Middle--Income Status by 2020Income Status by 2020

• High growthM d i fl i• Moderate inflation

• Stable exchange rate• Contained fiscal deficits

I. I. A Simple MetaphorA Simple MetaphorEconomy as a machine: fmachine: Transforming inputs such as

labor and capital into outputs such as goods and services.

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‘Economy as Machine’ Metaphor Suggeststhat for More Growth We Need …

More inputs!But many inputs such as land, labor or education are difficult to procure in the short run, so we need …

… more investment to increase our capital stock and achieve our growth objectives, at least in the short run!

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Alternatively, We Need to Use Our Existing Inputs More Efficiently!

This is about …

Technical innovation• Technical innovation (especially in advanced countries), leading to new products and production processes, and …

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• … adoption of best practices and existing technologies for emerging and developing countries

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II. II. Growth Through InvestmentGrowth Through InvestmentThe notion that investment into a nation’s capital stock is the key driver of growth was prominent in h ld lthe post-World War II era until

about the 1960s:• Following the destruction in WW II, capital was indeed the factor in short supply in many countries• Observation of large number of unemployed people during Great

d d l

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Depression and in developing countries—idea came to Sir Arthur Lewis while walking down the streets in Bangkok in the 1950s—also suggested that lack of capital is constraining growth whereas labor is abundant

The Financing Gap ModelThe Financing Gap ModelThis view of investment as growth-driver led to a development model that focused on investment and financing gaps:

h d d h1. Choose desired growth rate2. Compute required investment rate3. Determine available domestic savings to

finance investment, leading to investment/savings gap

4. Calculate financing gap that allows implementing investment projects not covered through domestic savings

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g g5. Fill this financing gap with aid

The first part of this chain—i.e., choosing a desired growth rate and computing required investment—has some resemblance to thinking about growth in Lao P.D.R., so the history of the financing gap model may be of interest.

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It Did Not Fare Very Well …• Despite decades of development aid, poverty could not be eradicated in many co ntries hich cast do bt oncountries, which cast doubt on the effectiveness of the financing gap model• In the 1970/80s, rise of neoclassical theory in economics began to emphasize ‘getting the price right’ and ‘resource allocation’ versus ‘resource quantity’

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• Empirically, Easterly showed that the aid-investment-growth linkage had little predictive power• This is also true for the investment-growth linkage itself!

Investment and Growth in Lao P.D.R.Investment and Growth in Lao P.D.R.As a starting point for our investigation, we need to specify the investment-growth link more precisely: We assume that the level of output, Yt, depends only on the level We assume that the level of output, Yt, depends only on the levelof the capital stock, Kt, in the economy and on nothing else! Specifically, they are proportional to each other with the factor A:

It can be shown this implies that the growth rate of real GDP, growtht, moves proportionally with the ratio of investment to previous year’s GDP:

So how closely do real GDP growth in Lao and the investment-to-GDP ratio move together?

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A First Look at the Link Between Investment and Growth In Lao P.D.R.:

What Do You See? Broad co-

Investment and Real GDP Growth in Lao P.D.R.

Broad comovement between growth and investment (good news!)

But not always—d h f 5%

10%15%20%25%30%35%40%

2.0%

4.0%

6.0%

8.0%

10.0%

good enough for forecasting and policy?

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0%0.0% 2000200120022003200420052006200720082009201020112012

GDP growth in % (constant prices)Investment-to-GDP(t-1) ratio (right axis)

Computing the ICORProportionality factor A is often expressed as 1/ICOR: ICOR stands for ‘Incremental

Capital Output Ratio’, which

For us, the economic interpretation is secondary. Rather, the question is how stable the ICOR is: if it is stable, projections and policy analysis is easyCapital Output Ratio , which

indicates that it can be computed as

4.0

5.0

6.0ICOR in Lao P.D.R.

So, how stable is ICOR in Lao P.D.R.?projections and policy analysis is easy

Alternatively, ICOR can be computed by dividing investment ratio with real GDP

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0.0

1.0

2.0

3.0

2000200120022003200420052006200720082009201020112012

growth rate ICOR is typically between 2-5; economic interpretation: low ICOR implies that investment generates a lot of growth

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Computing the ICOR—Exercise

Your task is to determine the required investment-to-GDP ratio that is necessary toratio that is necessary to obtain 8% real GDP growth rate in 2013: Consider a range of

plausible assumptions for the ICOR

What range do you obtain for the requiredfor the required investment ratios?

How do you incorporate factors other than investment?

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III. III. Growth Accounting ApproachGrowth Accounting ApproachBased on neoclassicalgrowth theory:• Emphasizes role of

k t d i fmarkets and prices for resource allocation• Considers broader set of inputs (especially labor and education in addition to physical capital)• In the long run, only labor force growth and technical

f h

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progress matter for growth rate

Key role for efficiency gains as driver of growth!

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Investment and Growth in the Neoclassical ViewInvestment and Growth in the Neoclassical ViewAnother implication of neoclassical growth theory is that investment-to-GDP ratio matters in the long 14.0%

GDP Growth (in %)

grun only for the level of GDP but not for the growth rate. Simulation of neoclassical growth model:• Baseline has 20% investment-to-GDP ratio and real GDP growth rate of 7.7% per annum 8.0%

9.0%

10.0%

11.0%

12.0%

13.0%

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• Alternative raises investment-to-GDP ratio to 30% permanently Impact on GDP growth fades away over time

6.0%

7.0%

2010

2014

2018

2022

2026

2030

2034

2038

2042

2046

2050

Base Scaling up In ICOR-type model, real GDP growth would rise permanently but not so in neoclassical model!

Growth AccountingGrowth Accounting

Growth accounting is based on production function that typically includes following growth factors:yp y g g Growth rate of capital, which is closely linked to a

nation’s investment rate Growth rate of ‘Raw’ labor, i.e., growth in labor force

measured in the number of available workers Growth of human capital, i.e., growth in the quality of

individual workers, often linked to schooling Technical progress, i.e., increase in efficiency of using

above input factors, often called growth rate of totalabove input factors, often called growth rate of total factor productivity (TFP)

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This implies growth can be expressed as follows:

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Growth Accounting—FindingsThe purpose of growth accounting is typically to quantify the contributions of the individual growth factors to a country’s growth performance with TFP growth computedcountry s growth performance, with TFP growth computed as a residual.So what are typically the most important growth drivers?• For advanced economies, TFP growth is often key

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Growth Accounting—Findings

Capital deepening was on average the singleon average the single most important growth driver Closely followed by TFP growth, probably resulting from the transition to market economies and resulting efficiency gainsefficiency gains Growth in the labor force played a negligible role (but study does not account for human capital)

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Growth Accounting—Findings

Capital deepening wasCapital deepening was especially important in Asia, resulting from very high investment (and savings) ratio

H i l l i

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Human capital accumulation was another key factor in East Asia during 1966-90 [Young study]

What do the Growth-Accounting findings imply for Lao P.D.R.?

Capital deepening was historically probably a main driver of growthdriver of growth For recent years, it might be useful to distinguish between the resource and non-resource economy Ongoing transition to market economy should yield efficiency gains (TFP growth) Greater trade integration through WTO

b hi h ld l b TFP hmembership should also boost TFP growth Scope for increasing education levels would yield sizeable contribution of human capital to growth

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IV. Recent IMF Research Results on IV. Recent IMF Research Results on Growth FactorsGrowth Factors

Investment is associated with higher growth …Real Investment (percent of GDP)

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25

0

5

10

15

20

0t [–4,0] t [1,5]* t [6,10]**

LICs with strong growthLICs with weak growth

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… and FDI appears especially beneficial:

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Net Foreign Direct Investment Flows(percent of GDP)

0

1

2

3

4

t [–4,0]*** t [1,5]* t [6,10]**LICs with strong growthLICs with weak growth

Growth takeoffs are associated with openness:

40Real Exports (percent of GDP)

0

10

20

30

40

t [–4,0] t [1,5] t [6,10]**LICs with strong growthLICs with weak growth

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Reigning in high inflation promotes growth:

25Inflation (1990-2011)

05

10152025

0t [–4,0]*** t [1,5] t [6,10]**

LICs with strong growthLICs with weak growth

Role of Inflation for GrowthTo explain the role of inflation for growth we will need multiple steps:1 I i i k f1. Innovation is key source of

growth (in growth-accounting terms, innovation is driver of TFP growth and matters for investment as well)

2. Innovation is a search process h f l hwith many failures that is not

easily centrally steered

Innovation tends to thrive in a market-based economy

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3. Market economy fosters innovation and growth but it

Role of Inflation for Growth (continued)

4. Prices are key coordination mechanism for a market economy;they help balance supply and demand

and growth but it is complex

supply and demand as well as allocate resources to their most productive uses

5. Price mechanism works best against a background of stable prices i e low

Role of Inflation for Growth (continued)

of stable prices, i.e., low inflation and stable exchange rate, because this makes it easy to identify price signals.

6. High inflation makes it difficult to distinguishdifficult to distinguish price signal from general price increases, adversely impacting coordination mechanism of market economy, thereby undermining growth

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Consequently, Vision 2020 makes the right call by combining its growth ambitions with

Role of Inflation for Growth (continued)

the maintenance of macroeconomic stability, including moderate inflation!

Thank You!

In the next exercise, you can propose your own ideas for growth-promoting policies in Lao P D R and express your view onP.D.R. and express your view on their likely growth impact!