CFA Level II Exam · Economic Growth

Sources of Economic Growth for CFA Level II

Updated 7 October 2026 · Fact-checked

Long-run growth comes from more inputs (labor, human capital, physical capital, natural resources) and from better use of them (technology, or total factor productivity). The production function approach splits output growth into input contributions plus technology. Labor productivity growth is output per worker growth, driven by capital per worker and technology.

Understand Sources of Economic Growth

Economic growth is the rise in an economy's potential output over time. Short-run swings in GDP come from the business cycle. Long-run growth comes from the supply side: what the economy can produce when its resources are fully used.

There are two ways to grow. You can use more inputs, or you can get more output from the same inputs. The inputs are labor (number of workers and hours), human capital (skills, education, health), physical capital (machinery, buildings, infrastructure), and natural resources (land, oil, minerals, water). Getting more from the same inputs is technology, often measured as total factor productivity (TFP).

The production function approach writes output as a function of these inputs. The common form is Cobb-Douglas: Y = A × K^α × L^(1-α). A is TFP, K is capital, L is labor, and α is capital's share of income. Taking growth rates turns this into the growth accounting equation, which splits output growth into the part from capital, the part from labor, and the leftover, which is TFP growth (the Solow residual).

Dividing by labor gives the per-worker form. Output per worker depends on capital per worker and technology. Because of diminishing marginal returns to capital, adding capital alone raises productivity by less and less. Sustained growth in output per worker therefore needs technology growth. Natural resources help, but resource-rich economies do not always grow faster, and some resources are non-renewable.

In the exam you will be given growth rates in a vignette and asked to attribute growth to sources, find TFP growth, or judge which factor matters most for a country.

Key formulas to remember

Cobb-Douglas production function: Y = A × K^α × L^(1-α); Assumes constant returns to scale. α is capital's share of output, 1-α is labor's share.
Growth accounting equation: ΔY/Y = ΔA/A + α(ΔK/K) + (1-α)(ΔL/L); ΔA/A is TFP growth, found as the residual. Use growth rates as decimals or percentages consistently.
Per-worker production function: Y/L = A × (K/L)^α; Output per worker depends on capital per worker and technology.
Labor productivity growth: Growth in Y/L ≈ ΔA/A + α × growth in (K/L); Also approximately equals growth in Y minus growth in L (or hours).
Potential GDP growth (labor force approach): Growth in potential GDP = growth in labor input + growth in labor productivity; Labor input is the labor force or total hours worked.

How to solve Sources of Economic Growth questions

Use this order for any question on sources of growth. It keeps you from mixing up total growth and per-worker growth.

1Read the vignette and list the data given: growth of output, capital, labor, and the capital share α.
2Decide what is asked: total output growth, TFP growth, labor productivity growth, or a qualitative source of growth.
3Identify the labor share as 1 - α if it is not given.
4For TFP, use ΔA/A = ΔY/Y - α(ΔK/K) - (1-α)(ΔL/L).
5For labor productivity, use growth in Y minus growth in L, or α times growth in capital per worker plus TFP growth.
6Check that all rates are in the same units and the same period.
7For qualitative questions, match the factor to the source: more capital per worker has diminishing returns, technology gives sustained growth.
8Check your work: the input contributions plus TFP growth must add up to output growth.

Quickest way: Residual shortcut for TFP

When to use it: Use when the vignette gives output, capital and labor growth and the capital share, and asks for TFP or productivity.

Write α and 1-α next to the growth numbers.
Multiply each input growth by its share and add them.
Subtract that sum from output growth to get TFP growth.
For labor productivity, subtract labor growth from output growth.
Eliminate options that ignore the share weights.

Common mistakes in Sources of Economic Growth

Adding capital and labor growth without weighting them by income shares.
Students treat the equation as a simple sum.
Fix: Always multiply capital growth by α and labor growth by (1-α) before adding.
Using α as labor's share.
The exponent on K is easy to confuse with the exponent on L.
Fix: α belongs to capital. Labor gets 1 - α.
Confusing labor productivity growth with output growth.
Both are described as growth in output.
Fix: Labor productivity is output per worker or per hour. Subtract labor growth from output growth.
Claiming that more capital alone gives sustained growth in output per worker.
Capital seems like the obvious driver.
Fix: Remember diminishing marginal returns. Only technology growth sustains per-worker growth in the neoclassical view.
Treating TFP as something you are given.
It sounds like a data input.
Fix: TFP growth is the residual left after accounting for weighted input growth.
Counting human capital as part of physical capital.
Both are called capital.
Fix: Human capital is skills and education embodied in workers. It raises labor quality and is separate from machinery and buildings.

Worked examples

Example 1

Vignette: An economy's output grew 4.0% a year. Capital grew 5.0% and labor grew 1.0%. Capital's share of income is 0.40. Q1: What is TFP growth? Q2: What is labor productivity growth?

Show the solution

Labor share = 1 - 0.40 = 0.60.
Capital contribution = 0.40 × 5.0% = 2.0%.
Labor contribution = 0.60 × 1.0% = 0.6%.
Sum of input contributions = 2.0% + 0.6% = 2.6%.
TFP growth = 4.0% - 2.6% = 1.4%.
Labor productivity growth ≈ output growth - labor growth = 4.0% - 1.0% = 3.0%.

Answer: TFP growth is 1.4% and labor productivity growth is about 3.0%.

Example 2

Vignette: Country X has output growth of 3.5%, labor growth of 0.5% and TFP growth of 1.0%. Capital's share is 0.30. Q1: What is the growth rate of capital? Q2: How much of output growth comes from technology?

Show the solution

Labor share = 0.70, so labor contribution = 0.70 × 0.5% = 0.35%.
Output growth = TFP + α × capital growth + labor contribution.
3.5% = 1.0% + 0.30 × g + 0.35%.
0.30 × g = 3.5% - 1.0% - 0.35% = 2.15%.
g = 2.15% ÷ 0.30 = 7.17% (approximately).
Technology share of output growth = 1.0% ÷ 3.5% = 28.6% (approximately).

Answer: Capital grew about 7.17% a year, and technology accounts for about 28.6% of output growth.

Exam tips

Write α next to the numbers first. Most errors come from swapping the shares.
Check whether the question asks for total output growth or per-worker growth.
Expect a qualitative question on which factor can sustain growth. The answer is technology, not capital alone.
If TFP is not given, assume you must compute it as the residual.
Watch for hours worked versus number of workers when computing productivity.

Sources of Economic Growth: frequently asked questions

What are the main sources of economic growth?

Labor, human capital, physical capital, natural resources and technology. Technology is measured as total factor productivity, which captures how efficiently the inputs are combined.

How do I calculate labor productivity growth?

Subtract growth in labor input from growth in output. You can also use α times growth in capital per worker plus TFP growth.

What is total factor productivity?

TFP is the part of output growth not explained by growth in capital and labor. It is found as a residual in the growth accounting equation and reflects technology and efficiency.

Why do diminishing returns matter for growth?

Each extra unit of capital per worker adds less output than the one before. Capital deepening alone therefore cannot sustain growth in output per worker without technological progress.