Wednesday, May 18, 2011

Incremental Capital-Output Ratio

Incremental Capital-Output Ratio (ICOR)

The incremental capital output ratio (ICOR) is defined as the ratio between investment in some previous period(s) and the growth in output in the subsequent period. Needless to say, ICOR calculation is based on constant price data.

There are several critical points to be mentioned about this ratio: (i) Growth in output can be due to several other factors than investment in new capital, e.g., growth in productivity, production capacity utilization rate, and (ii) The 'investment - increase in output' lag will vary. Thus, to obtain a reliable relationship the measurement of ICOR should be estimated for a longer period, perhaps three or four decades.
The period used to compute ICOR should be as “normal” as possible, however, it might be difficult to recognize a 'normal' period. A pragmatic solution to this problem is to derive ICOR on the basis of several periods.

The above method smooths out periods with extremely high or low investments, however, if the periods 0 and/or t have extremely low or high use of capacity this method will give a ‘wrong’ picture of the average capital output ratio.
ICOR has been used since the 1950's, and is still used by the Bank and other international organizations for instance to measure required investment to reach the targeted GDP growth.
If a country has an investment rate of four percent of GDP and an ICOR of four, growth in GDP will be one percent per year. If the population is growing faster than one percent per year, GDP per capita will fall. Alternatively, lets say that the targeted GDP growth is five percent next year, then required investment this year is 20 percent of GDP.

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