Growth Accounting and Influencing Factors

Growth Accounting Relations

Using the Cobb Douglas production function, the growth in potential GDP can be expressed using the growth accounting relation as:

or

In practice, levels of capital and labor are forecasted from their long term trends, and the shares of capital and labor determined from national income accounts. The change in total factor productivity (technology) is not directly observable. Therefore, it must be estimated as a residual: the ex post (realized) change in output minus the output implied by ex post changes in labor and capital.

The growth accounting equation is also useful in determining the comparative effects of increasing different inputs. If labor growth accounts for the majority of economic growth, for example, analysts should be concerned with a country’s ability to continue to increase its labor force. The relation can also be used to estimate potential output, as illustrated in the following example.

Natural resources include both renewable resources, such as timber, and non renewable resources, such as oil and gas. The role of natural resources in economic growth is complex. In some instances, countries with abundant natural resources (e.g., Brazil) have grown rapidly.

Yet other countries (e.g., some of the resource rich countries of Africa) have not. Conversely, some resource poor countries have managed impressive growth.

One reason that limited natural resources do not necessarily constrain economic growth is that access to natural resources does not require ownership of resources. Resource poor countries may be able to access resources via trade. Japan (日本), for example, has managed impressive growth and high per capita GDP despite having limited ownership of natural resources.

Other theories contend that ownership of natural resources may actually inhibit growth, because the economic energy of a country rich in natural resources may be focused on recovering those resources rather than developing other industries. Furthermore, countries that own valuable resources can find their currency appreciating as the demand for those resources increases. The so called “Dutch disease” refers to a situation where global demand for a country’s natural resources drives up the country’s currency values, making all exports more expensive and rendering other domestic industries uncompetitive in the global markets.

As stated previously, an increase in the quantity of labor will increase output, but not per capita output. Quantity of labor is defined as the size of the labor force multiplied by average hours worked. Labor force is defined as the number of working age (ages 16 to 64) people available to work, both employed and unemployed.

Labor Supply Factors

1. Demographics. A country’s demographics strongly influence its potential economic growth. As a country’s population ages and individuals live beyond working age, the labor force declines.

Conversely, countries with younger populations have higher potential growth. Furthermore, fertility rates drive population growth and thereby affect potential future economic output. Countries with low or declining fertility rates will likely face growth challenges from labor force declines.

2. Labor force participation. Labor force participation is defined as the proportion of working age population in the labor force.

• Labor force participation can increase as more women enter the workforce.

3. Immigration. Immigration poses a potential solution to a declining labor force. Countries with low population growth or adverse demographic shifts (older population) may find their growth constrained.

Since developed countries tend to have lower fertility rates than less developed countries, immigration represents a potential source of continued economic growth in developed countries.

4. Average hours worked. For most countries, the general trend in average hours worked is downward. Possible explanations include legislation limiting the number of hours worked, the “wealth effect” which induces individuals to take more leisure time, high tax rates on labor income, and an increase in part time and temporary workers.

Human capital. Human capital is knowledge and skills individuals possess. Unlike quantitative labor metrics, such as hours worked, human capital is a qualitative measure of the labor force.

Increasing human capital through education or work experience increases productivity and economic growth. Furthermore, human capital may have external spillover effects as knowledgeable workers innovate. Innovations are then used by society in general creating greater efficiencies economy wide.

Physical capital. Physical capital is generally separated into infrastructure, computers, and telecommunications capital (ICT) and non ICT capital (i.e., machinery, transportation, and non residential construction). Empirical research has found a strong positive correlation between investment in physical capital and GDP growth rates.

This result may seem inconsistent given our previous discussion about capital deepening and diminishing marginal returns to capital. Several explanations exist to explain why capital increases may still result in economic growth. First, many countries (e.g., developing economies) have relatively low capital to labor ratios, so increases in capital may still have significant impact on economic growth.

Second, capital investment can take different forms. Some capital investment actually influences technological progress, thereby increasing TFP and economic growth. For example, acceleration of spending in the IT sector has created what are termed network externalities.

Investment in IT networks may have multiplicative effects on productivity since IT network investment actually becomes more valuable as more people are connected to the network.

Technological development. Investment in technology includes investment in both physical and human capital. Technological innovation can manifest itself in processes, knowledge, information, machinery, and software, among other things.

Researchers have examined proxies for investment in technology such as research and development (R&D) spending or number of patents issued. Developed countries tend to spend the most on R&D since they rely on technological progress for growth given their high existing capital stock and slower population growth. In contrast, less developed countries often copy the technological innovations of developed countries and thus invest less in R&D as a percentage of GDP.

Ultimately, technological development should lead to increases in productivity as measured by GDP per worker. Developed countries tend to have very high levels of productivity by this measure while less developed countries tend to have greater potential for growth in productivity.

Public infrastructure. Investments in public infrastructure such as the construction of public roads, bridges, and municipal facilities, provide additional benefits to private investment. For example, an investment in distribution facilities by a private company would do little good without an interstate highway grid.

The highway system, therefore, enhances total productivity for the economy by complementing the private investment and increasing total factor productivity.