Economic Growth

Section: Economic Growth and the Investment Decision Estimated study time: 45 minutes Content: Economic growth — the sustained increase in an economy's productive capacity over time — is the foundation of long-run investment returns. Real GDP per capita growth determines the long-run growth in corporate earnings, dividends, and asset prices. The sources of economic growth are identified through the production function: Y = A × F(K, L), where Y is output, A is total factor productivity (TFP, the "Solow residual" measuring technological efficiency), K is physical capital, and L is labor. Growth in output comes from: (1) growth in labor inputs (population growth and labor force participation), (2) growth in physical capital (investment), (3) growth in human capital (education and skills), and (4) improvements in TFP (technology, institutions, resource allocation). TFP growth is the most powerful long-run growth driver because capital and labor face diminishing marginal returns. The Solow growth model explains long-run economic growth and convergence. In the Solow model, economies converge to a steady state where investment equals depreciation and output per worker is constant. Economies below their steady state grow rapidly; those above contract. Capital accumulation drives growth in the short to medium term, but in the long run, only technological progress (TFP growth) can sustain rising living standards — because capital faces diminishing returns. Conditional convergence predicts that countries with similar fundamentals (savings rates, institutions, human capital) will converge in income per capita over time. Unconditional convergence — the idea that all poor countries will catch up with rich ones — does not hold in practice; institutional quality, governance, and openness to trade matter enormously. Sustainable economic growth depends on institutional and policy factors beyond…