where α is a parameter between 0 and 1 that measures the relative importance of capital, and γ is a parameter that measures the extent of returns to scale. Reasonable values of α range from 0.3 to 0.5. If γ=1 (γ > 1) (γ < 1) there are constant (increasing) (decreasing) returns to scale. Reasonable values of γ range from 0.8 to 1.2. The second one is a constant-returns-to-scale constant elasticity of substitution production function: _F (K, H) = [αK_<sup>_ρ_</sup> _+ (1 - α)H_<sup>_(1 - ρ)_</sup> _]_<sup>_(1/ρ)_</sup> where _ρ_ = ( _σ_ -1)/ _σ_ is the elasticity of substitution between _K_ and _H_ . When _σ_ = 1 this reduces to the Cobb-Douglas case above with _γ_ = 1. Reasonable values of _σ_ range from 0.8 to 1.2.

To estimate the level and growth rate of _A_ , we require data on _Y_ , _K_ , _L_ , _D_ , _P_ , and _S_ . These are drawn from the following sources. Real GDP and gross domestic investment in constant 2000 U.S. dollars adjusted for differences in PPP come from World Bank’s _World Development Indicators_ . Data on population, the share of population aged 15-64, and the labor force participation rate are computed based on data from the World Bank’s _SIMA_ . We assume that the labor force participation rate is an average of the labor force participation rates for females and males. Data on the stock of years of education in 1989 and 1998 are obtained from Mongolia’s _Living Standards Measurement Survey_ (LSMS), 1998. Numbers for the other years were estimated assuming a constant annual growth rate in the human capital stock. The parameter _ф_ , which measures the returns to education (i.e. the percentage increase in worker productivity due to an additional year of education) is assumed to be 10 percent.

Capital stocks are constructed using the perpetual inventory method which requires information on the initial capital-output ratio in 1992, depreciation rates ( _δ_ ), and gross domestic investment in constant U.S. dollars adjusted for differences in PPP ( _I_ ). For most developing countries, reasonable values for the initial capital-output ratio range between 1 and 2, and for the depreciation rate are between 0.04 and 0.08. Following Ghosh and Kraay (2000) we use initial capital-output ratio of 1 and _δ_ = 0.06 in all calculations.

This analysis suggests that TFP growth has improved in recent years, and in 2004 productivity rose by nearly 5 percent (Figure 7). The result that productivity growth was positive in 2004 holds under all plausible sensitivity scenarios (Table 9).

Another way to measure the productivity of capital or the rate of return to capital ( _r_ ) is to compare the rate of real per capita GDP growth ( _g_ ) and the investment share in GDP ( _SI_ ) as in _r_ = _g_ /<sup>_S_</sup> _I_ . A cross-country regression of real per capita growth on investment shares in a sample of countries in Favaro (2005) suggests that countries with higher investment shares tend to grow at higher per capita growth rates. According to this estimation, Mongolia’s real per capita annual growth rate, which averaged 2.6 percent in the period 1996-2004, was much higher than the one suggested by the average of 2 percent for the countries in the sample.<sup>32</sup> In 2004, Mongolia’s rate of return to capital accelerated much above the average as real per capita growth climbed above 9.3 percent, while its investment share stayed close to 36 percent.

> 32 Mongolia’s average investment share for the period 1996-2004 was 34.4 percent.

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