CFA Level 2 – Economics Session 4 – Reading 14 Economic Growth

CFA Level 2 – Economics, Session 4 – Reading 14

Economic Growth – LOS a

(Notes, Practice Questions, Sample Questions)

1. Which of the following most completely identifies the institutions in an economy that are necessary for markets to be effective?

A) Property rights and a supporting legal system.
B) Property rights and monetary exchange.

C) A legal system and a central banking system.
Explanation: B — For markets to be effective, property rights and monetary exchange are required. If property rights are properly established and enforced, people will be assured that government will not confiscate their savings and investments.

Monetary exchange provides for the efficient exchange of goods and services
2. Which of the following is least likely to be considered as one of the three social institutions that are critical to the development of an incentive system?

A) Markets.
B) Property rights.
C) A specific form of political organization

Explanation: C — The three social institutions that are critical to the development of incentives are markets, property rights, and monetary exchange. Collectively, these three social institutions create incentives for people to specialize and trade, save and invest, and discover new technologies. A specific form of political organization is not necessary for economic growth as communist and authoritarian countries have experienced economic growth

3.1 Brent Bates, CFA, is a portfolio manager for a large money management firm located in New York. Analysts at the firm, led by Bates, have been following the development of the economic situation in Mexico after the signing of NAFTA in 1994, which lifted certain restrictions on investment in Mexico commerce by foreign firms.

After a period of adjustment, the firm believed the Mexican market presented opportunity for attractive investment returns. The firm has recently purchased a controlling interest in a commercial bank based in Mexico City. One of the first measures to be taken by the firm is to diversify the bank’s portfolio through investments in Central and South America. The firm believes that Bates’ expertise in the analysis of the Mexican economy will be beneficial is pursuing other Latin American investment opportunities.

Bates has identified two potential investments, both of which he believes will be in alignment with his firm’s investment criteria, and is ready to present his recommendations to the firm’s managing directors. One of Bates’ recommended investment opportunities is a company located in Country A, the largest country in South America, while the other is headquartered in Country B, a smaller Central American nation. Knowing that the firm’s partners have limited knowledge of the nuances of the Latin American economies, Bates decides to take a “macro” approach to his presentation by providing broad economic information about the current situations in the two countries.

Bates begins with the company located in Country A, which is one of the largest manufacturers of women’s shoes in South America. The country’s economy has battled extremely high rates of inflation in the past. Over the past decade, tough policies enacted by its government appear to have controlled inflation while at the same time allowed measurable growth in real GDP. In the past ten years, Country A’s real GDP per labor hour has increased from $8.00 per labor hour to $8.64 in this time period. Over the same time period, investment in new capital increased from $18.00 per labor hour to $18.90 per labor hour.

The company located in Country B has been operating in a much different economic climate than the first company. After a history of low productivity and a predominantly rural-based economy, the government of Country B has attempted to stimulate national productivity through a series of policies designed to promote more industrial commerce. Country B has established a multi-part system of incentives to encourage economic growth. Formerly state-run enterprises are increasingly being transferred into private ownership. The government of Country B has encouraged more foreign investment through less restrictive investment regulations. Also, interest rates are being carefully managed through accommodating fiscal and monetary policies to encourage growth.

According to the classical growth theory, Country A’s recent growth in real GDP:

A) is a result of the recent decrease in interest rates, which intensified incentives to discover new production methods that increase profitability.
B) is directly attributable to a decreased opportunity cost for women to enter the workplace.
C) will lead to an explosion in population growth that will eventually erase any gains in GDP per labor hour.

Explanation: C — A key component of the classical growth theory is that growth in GDP is always temporary. When real GDP per capita rises above a subsistence level, the population will grow, driving GDP per capita back down to its original level
3.2 In general, which of the following factors is credited with being the largest contributor to a country’s sustained economic growth?

A) Investment in new capital.
B) Discovery of new technologies.
C) Investment in human capital

Explanation: B — The discovery of new technologies has contributed more to sustained economic growth than investment in new capital or increased investment in human capital
3.3 The amount of Country A’s increase in GDP per labor hour that can be attributed to the change in capital per labor hour is closest to:

A) 1.67%.
B) 3.33%.
C) 2.50%

Explanation: A — According to the “one-third” rule, at a given level of technology, a one percent increase in capital per labor hour results in a 1/3 of 1% increase in real GDP per labor hour. If capital labor per hour grew by 5%, then the capital growth contribution to the increase in GDP is 1.67% (= 1/3 × 5%)
3.4 If in the next year, Country A’s investment in new capital increases by an additional $0.90 per labor hour, and the level of technology remains unchanged, GDP per labor hour will increase:

A) and the increase will be less than the increase resulting from the previous decade’s $0.90 increase in investment in new capital.
B) by the same amount as from the previous decade’s $0.90 increase in investment in new capital.
C) and the increase will be greater than the increase resulting from the previous decade’s $0.90 increase in investment in new capital.

Explanation: A — In accordance with the law of diminishing returns, at a given level of technology, the increase in GDP per labor hour will decrease as incremental capital per labor hour is added.
3.5 Country B has implemented policies to ensure that an adequate incentive system is in place to foster economic development in the country. Which of the following are the three components necessary for a country to establish such a system?

A) Property rights, monetary exchange, and investment in human capital.
B) Markets, property rights, and monetary exchange.
C) Markets, property rights, and investment in human capital.

Explanation: B — The three most basic components necessary for a country’s economic growth are markets, property rights, and monetary exchange. Markets allow for the exchange of information among buyers and sellers. Property rights give assurance that no entity can confiscate savings and investments of a country’s citizens. Monetary exchange facilitates the efficient exchange of goods and services.
3.6 According to the basic principles of the new growth theory, the government of Country B will succeed in fostering new economic development in their country through:

A) an increase in capital accumulation.
B) an increase in labor productivity.
C) a decrease in real interest rates

Explanation: C — The new growth theory contends that the two main catalysts of growth are the creation of knowledge capital and lower real interest rates
4.1 Rob Hartwell, CFA, is a portfolio manager whose client base is primarily comprised of high net worth individuals. Hartwell has been hired by Joan McCarthy, a highly successful entrepreneur who has recently retired from her position as CEO of her company. Prior to the retention of Hartwell, McCarthy’s portfolio had been poorly managed by another investment advisor who had never formulated an investment policy for her and had invested Hartwell’s money in assets that were not particularly suitable for either her risk tolerance or her return requirements. One of Hartwell’s first tasks as McCarthy’s new portfolio manager is to formulate an investment policy for McCarthy in light of her new retirement status, taking into account her current and future needs for income-generating investment vehicles. Hartwell will then evaluate all current holdings and determine, on an individual basis and with regards to the portfolio as a whole, whether each position should be retained or liquidated.

Hartwell identifies two large positions in companies located in Slotvenski, an Eastern European country that, until twenty years ago, was under communist rule. The investments are in two manufacturing concerns: one that produces paper products for domestic use, while the other manufactures leather goods for export to EU countries and the United States. Hartwell believes that the fundamental financial analysis of the two corporations should be relatively straightforward, but knows that he must first gain a firm understanding of the country’s economic climate in order to evaluate the investments in the context of the overall portfolio.

Since the early 1990s, the government of Slotvenski has worked to replace its country’s formerly closed economy with a free market system with the hope of encouraging domestic economic growth. Policies were formulated specifically to create incentives for the country’s citizens to trade, invest and develop new technologies. As a result, over the past decade, the country has experienced a twenty percent increase in the growth rate of its labor productivity. In addition, over the same time period, the country has enjoyed an eight percent increase in the real GDP per labor hour. On the surface, both of these developments would appear to be of benefit to McCarthy’s investments in the developing country.

Hartwell is impressed by Slotvenski’s recent economic progress, but in light of McCarthy’s return parameters, he wants to do further analysis to attempt to determine whether or not this pattern of growth is sustainable in the future. He first will evaluate the country’s economic progress to determine which of the three predominant growth theories is most applicable to this situation. He observes that over the past decade, real interest rates have declined slightly, and Hartwell must determine what impact this may have on future economic growth.

In his analysis, Hartwell also notes several demographic trends emerging in the country’s economy. Of particular interest to Harwell is the change in the composition of the country’s workforce. As the country has become more industrialized, more opportunities for women to enter the workforce have led to a slight decrease in the country’s birth rate. At the same time, increased disposable income per capita has led to an increased domestic demand for consumer goods.

An incentive system that will encourage a country’s economy to realize economic growth is composed of three main social institutions. Which of the following institutions must be present for a society to be able to create incentives for economic growth?

A) Increased labor productivity.
B) Establishment of property rights.
C) Savings and investment in new capital

Explanation: B — Property rights must be established to assure citizens and foreign investors alike that the government will never confiscate their savings and investments
4.2 With a proper incentive system in place, the economic growth of a country will least likely come from which of the following sources?

A) Investment in human capital.
B) The efficient exchange of goods and services.
C) Increased savings and investment in new capital

Explanation: B — A monetary system that allows for the efficient exchange of goods and services is an integral part of the incentive system that must exist in order for a country to realize economic growth. Investment in human capital, technological advancements, increased savings, and investment in new capital are the actual sources of economic growth.
4.3 Which of the following statements regarding the growth rate of labor productivity is most accurate?

A) The two factors that contribute to the growth of labor productivity are growth in physical capital per labor hour and technological change.
B) Labor productivity can be quantified as capital per labor hour.
C) Technological change is largely dependent upon growth in savings and investment in physical capital.

Explanation: A — Labor productivity is calculated by dividing real GDP by aggregate labor hours, and the two factors having the greatest influence on labor productivity are growth in physical capital per labor hour and technological change.
4.4 Assuming that the Slotvenski economy experiences a 6 percent increase in capital per labor hour, calculate the amount of the increase in real pre capital GDP per labor hour attributable to investment in new capital and the amount attributable to technological advancement.

Investment in New
Capital Advancement Technological Advancement

A) 6.00% 2.00%
B) 2.00% 6.00%
C) 2.67% 5.33%

Explanation: B — The one-third rule states that at a given level of technology, a one percent increase in capital per labor hour will result in a one third of one percent increase in real GDP per labor hour. Thus, capital per labor hour contributed 2 percent of the increase (1/3 × 6 percent) while technological change contributed the remaining 6 percent of the increase (8 percent – 2 percent)
4.5 In accordance with the new growth theory, a decrease in real interest rates:

A) will act as an incentive for people to discover new products and technology.
B) will have little or no effect on population growth.
C) is caused by an accumulation of capital, which will eventually stifle economic growth.

Explanation: A — Under the new growth theory, lower real interest rates will increase the drive to discover new products and technology in order to earn higher profits.
4.6 The economic theory that argues that the most important economic influence on population growth in a society is the opportunity cost to women for entering the workplace is:

A) new growth theory.
B) neoclassical growth theory.
C) classical growth theory.

Explanation: B — Neoclassical growth theory differs significantly from other growth theories in the assumptions that population growth is not simply a matter of adjustment centered on the subsistence real wage rate. Neoclassic economists believe that as the opportunity cost of having children increases for women, birth rates decline and population growth slows.
5. Which of the following is the most basic precondition to economic growth?

A) Property rights.
B) Markets.
C) An incentive system.

Explanation: C — A suitable incentive system is the most basic precondition that must exist in order for a society to realize economic growth. The three social institutions that are critical to the development of incentives are markets, property rights, and monetary exchange. Collectively, these three social institutions create incentives for people to specialize and trade, save and invest, and discover new technologies

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