F.

Roth

Finance

How to estimate long-term potential growth

1. Estimating the Rate of Growth in Potential GDP

Table 1 provides data on the growth rate in aggregate hours worked and productivity growth for
different countries.

a. Estimate the growth rate of potential GDP for each country by averaging the growth rates for
these variables since 2001.
b. Also, describe the role that the labor input plays in determining potential growth for each
country.

Table 1: Aggregate Hours Worked and Productivity: Average Annual Growth

Rate (%)
Aggregate Hours Worked Productivity

2011-2018 2001-2010 2011-2018 2001-2010

Canada 0.9 1.4 1.0 0.9
Germany 0.5 0.2 1.1 0.9
Japan 0.3 -0.2 0.8 1.2
US 0.7 0.7 1.5 0.8

Solution:

Potential GDP is calculated as the sum of the trend growth rate in the aggregate hours worked,
(labour input) and the trend growth rate in labour productivity. The growth in the labor input
depends on the population growth rate, changes in the labor force participation rate, and changes in
hours worked per person. Estimating based on the average for the period from 2001-2018 gives the
following data.

Projected Growth in Projected Growth in

Projected Growth in
% Aggregate Hours Potential GDP
Labor Productivity
Worked
Canada 1.2 0.9 2.1
Germany 0.3 1.0 1.3
Japan 0.0 1.0 1.0
US 0.7 1.1 1.8

Most of the difference between the growth rates in potential GDP among these countries can be
explained by the labor input. The most significant result is the difference in the growth rate in
aggregate hours in Germany and Japan, in contrast to that in the United States and Canada. The
results suggest that Japan's sluggish economic growth is likely to continue because of the lack of
growth in the labor input.

2. Estimating the potential growth rate: The Irish Case

Economic growth in Ireland since 1980 has been significantly higher than that experienced in the
major European economies. In 1970, the per capita GDP of Ireland was 45.2% below the per capita
GDP of the UK. By 2010, per capita GDP in Ireland caught up with or exceeded most other developed
European countries.

Like most of the global economy, Ireland fell into a deep recession in 2009, with GDP contracting by
more than 7%, before staging a recovery and reaching annual growth of more than 5% for several
years in the 2010-2018 period. To understand the factors driving the Irish economy and the
prospects for future equity earnings, use the following data (table 2) to address these questions:

a. Evaluate the sources of growth for the Irish economy starting from 1995.

Solution:

The sources of growth for an economy include labour quantity, labour quality, non-ICT capital, ICT
capital, and TFP.

In sum, the main driver of growth for the Irish economy since 1995 has been capital spending. It
accounted for more than 45% of growth in 1995 and 2005, and has been the dominant factor
contributing to growth in the Irish economy since 2005.

To estimate the growth rate in potential GDP, you can use the following equation:

Growth rate of potential GDP = Long-term growth rate of labor force + Long-term growth rate in
labor productivity

The total hours worked are one potential source to use to estimate the growth rate of the labor
input. For Ireland, the labor input increasing by 3.2% annually between 1995 and 2005, and by 0.6%
annually between 2005 and 2018. You also assume the following:

- Labor productivity grows at the same rate as TFP

- TFP growth reverts to its average growth rate in the 1995-2005 period

b. What is likely to happen to the potential rate of growth for Ireland? What are the prospects
for equity returns?

Solution:

Growth in potential GDP is 0.3% + 1.7% = 2.0%

In summary, despite the projected rebound in TFP growth, overall potential growth in Ireland is likely
to decline because labor input growth in particular no longer contribute to overall growth.

Slower growth in potential GDP will limit potential earnings growth and equity appreciation.

Table 2: GDP of Ireland, contribution from:

 Input 1995-2005 2005-2018
Labor
Labor quantity 2.0% 0.0%
Labor quality 0.3% 0.3%
Capital/Investment
Non-ICT capital 2.6% 2.5%
ICT capital 0.7% 0.3%
TFP 1.7% 0.1%

3. Prospects for Fixed-Income Investments

At the end of 2018, you consider the OECD's GDP forecast for different countries. The forecast is
given in table 3, along with the potential GDP growth estimates the analyst has calculated.

To evaluate the future prospects for fixed-income investments, you must estimate the future rate of
inflation and assess the possibility of changes in monetary policy by the central bank. An important
indicator for both of these factors is the degree of slack in the economy, which can be measured by
comparing the growth rates of actual GDP and potential GDP.

a. Based on the information in table 3, evaluate the prospects for fixed-income investments in
each country.

Table 3: Projected vs. Potential GDP Growth (%)

Projected Average Annual Projected Growth in
GDP Growth (2019-2020) Potential GDP
Canada 4.0 2.1
Germany 1.5 1.3
Japan 0.0 1.0
US 3.5 1.8

Solution:

In comparing the OECD forecast for GDP growth with the estimated growth rate in potential GDP,
there are two cases to consider:

- If actual GDP is growing at a faster rate than potential GDP, it signals growing inflationary
pressures and an increased likelihood that the central bank will raise interest rates.
- If actual GDP is growing at a slower rate than potential GDP, it signals growing resource lack,
less inflationary pressures, and an increased likelihood that the central bank will reduce rates
or leave them unchanged.

Projected and potential GDP for the aforementioned countries can be compared referring to Table 3.
The data suggests that inflationary pressure will grow in the United States and Canada and that both
the Federal Reserve and the Bank of Canada will eventually raise interest rates. Thus, the
environment for bond investing is not favourable in the United States and Canada because bond
prices are likely to decline.

With Germany growing at close to its potential rate of GDP growth, the rate of inflation should
neither rise nor fall. Monetary policy is set by the European Central Bank, ECB, but data on the
German economy play a big role in the ECB's decision. Based on the data in Table 3, no change in ECB
policy is likely. For bond investors, little change in bond prices is likely in Germany, so investors need
to focus on the interest income received from the bond. Finally, growing resource lack in Japan will
put downward pressure on inflation and may force the Bank of Japan to keep rates low. Bond prices
should rise in this environment.