Chapter VI: Capital, Investment, and International Capital Flows

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Chapter VI Capital, Investment, and
International Capital Flows

• A. The determinants of savings
• B. The investment decision
• C. Marginal product of capital and user costs of
  capital
• D. Capital flows in the global economy
• Cases The U.S. and LDCs

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The capital market
Households receive income, consume and save Buy
debt and equity

1. Firms issue debt, equity
2. Governments issue debt

Savings
Investment
Capital Market
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Again I S

• The capital clears in a closed economy if S I
• Savings can be decomposed into household and
  government savings
• Household savings is SP Y - T - C
• Government savings is SG T - G
• We obtain SP SG I

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Determinants of savings

• Savings depends on
• The level of income
• The interest rate
• Government policies

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Shifts in the S-curve
If government outlays increase, the S-curve
shifts to the left
If income increases, the S-curve shifts to the
right
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Crowding out

• In a closed economy, government could crowd out
  private investors
• It means increasing public spending, i.e.
  reducing government saving
• It will increase the market interest rate

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Crowding out and theMaastricht Stability Pact

• The fact that governments can crowd out other
  participants of the capital market caused concern
  when the new European currency was created
• In order to control this effect, the EU member
  states have adopted the so-called Maastricht
  budget criteria
• Level of government debt lt 60 of GDP
• Annual budget deficit lt 3 of GDP

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The Maastricht budget criteria

• The purpose is to limit the impact of government
  borrowing on interest rates
• France, Germany, Italy and other eurozone
  countries are persistently violating the deficit
  criterion
• Violation of the criteria may entail sanctions
  (fines)

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The market for EMU government bonds
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Impact of crowding out

• It is obvious that the impact of crowding out
  is greatest for the largest countries, not for
  smaller countries such as Portugal and Greece
• But interestingly, it is exactly in the larger
  countries where the complaints about too high
  real interest rates are loudest

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Fiscal positions (1)
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Fiscal positions (2)
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Reading

• Abel, Bernanke and Croushore, Chapter 4.1
  (without Applications)

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The stock of capital

• Investments consist of the purchase or
  construction of capital goods, including
• residential and nonresidential buildings,
• equipment and software used in production,
• and additions to the inventory stock
• The capital stock develops in line with
  investment in the following way Kt Kt-1 ? (1
  - d) It

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Net investment

• The usage of capital requires the firm to replace
  existing capital (d ? Kt-1)
• This part of investment is called replacement
  investment (or depreciation)
• The difference between gross investment and
  replacement investment is called net
  investment
• Only net investment will expand the capital stock

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Investment and the production cycle
Percentage increase p.a.
Source Worldbank
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The investment decision

• A firm expands its capital stock only if it
  expects some profit from it
• More precisely the investment is expected to
  generate a resource flow that covers at least
  current costs (wages, material, energy), plus a
  residual
• This residual is the return on investment

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Neoclassical investment theory

• The neoclassical theory of investment has
  benefited from the work of Dale W. Jorgenson
  (Harvard)
• It is useful when making decisions on the
  purchase of equipment

Dale W. Jorgenson 1933
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Two types of firms

• We consider two types of firms
• Producers. They use capital goods which they rent
  from leasing firms
• Leasing firms. They demand investment goods and
  lease them to producers
• Producers pay a rental price for using the
  capital good

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Marginal product and rental price of capital

• The return on investment of the firm isequal to
  the marginal product of capital (MPK) times the
  price of its final product R P ? MPK P ?
  ?F(L,K) / ?Kor R/P MPK
• The rental price of the capital good cannot be
  higher than the real return on investment, or the
  producer makes a loss

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The marginal product of capital
Expected MPK
MPK
Capital stock
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The user costs of capital

• Now we ask which costs the leasing firm will have
  to bear (user costs of capital Ucc ) when
  purchasing a capital good at the price of PK
• There are three types of costs
• Opportunity costs of financing i PK
• Depreciation d PK
• Capital losses (and gains) - ? PK.

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User costs of capital

• The user costs of capital are the higher,
• The higher the interest rate i
• The higher the depreciation rate d
• And the higher the risk of falling prices of the
  asset, and the dimension of the price change

Ucc i PK d PK - ?PK PK (i d - ?PK / PK
)
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Fisher-Gleichung

• We assume that ?PK / PKchanges with the general
  rateof inflation ?
• Furthermore the following relationship between
  real and nominal interest rates holds (Fisher
  equation) i r ?
• It eliminates the need to consider capital losses

Irving Fisher1867-1947
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Determining the desiredcapital stock

• We now consider the profit per unit of capital in
  order to determine the desired capital stock
• Unit profit Unit return (gross) - unit costs
  P ? MPK - PK ( r d )
• The change of the capital stock (net investment)
  depends on unit profits
• As long as unit profits are positive, there will
  by net investment, and the capital stock grows

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Investment function

• Net investment is therefore ? K I net
  Inet MPK - PK/P ? (r d)
• And including replacement investment we
  obtain

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The desired capital stock
Expected MPK, and Ucc
Ucc
MPK
Capital stock
K
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Changes in the desired capital stock (1)
Expected MPK, and Ucc
A lowering of the real interest ratewill
decrease Ucc and encouragenet investment to
expand the desiredcapital stock
Ucc1
MPK
Capital stock
K1
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User cost of capital in theglobal economy

• The user costs of capital also depend on taxes
  and other capital charges
• In a competitive international environment, the
  net-of-tax profit rate determines investment
• International capital flows are driven by tax
  competition among governments

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User cost of capital and taxes

• The real interest rate is just one component of
  Ucc, and it should be rather uniform within the
  euro area
• If countries have negative net foreign investment
  this is likely to reflect other components of
  Ucc, including taxes
• Ucc drives the mobility of fresh capital
• Once installed, fixed capital is usually locked
  in, at least for some time

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Changes in the desired capital stock (2)
Expected MPK, and Ucc
A technological advance willincrease MPK and
encouragenet investment to expand the
desiredcapital stock
Ucc1
MPK,1
Capital stock
K1
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MPK in the global economy

• International capital flows are also driven by
  evolving differences in MPK
• Technical and organizational progress of an
  economy and innovation tends to attract
  international investments
• The MPK curve can also be dragged down by
  government interventions, red tape,
  over-regulation, and market rigidities

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Savings and investmentequilibrium
Real interest rate, r
Saving, S
E
Investment, I
Desired national saving, and desired investment
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Reading

• Abel, Bernanke and Croushore, Chapter 4
  (without Appendix)

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Returning to the United States
Source Economist
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US trade (percentages of total)Year-to-Date 2005
March
Source U.S. Census Bureau
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US Deficit by major trading partner
Source U.S. Census Bureau
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2004 Global current account ( bill. IMF and
Roubini/Setzer)
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Global balance?
IMF and Roubini/Setzer
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Current balance and foreign capital account

• A current account deficit or surplus CBt entails
  international capital or financial flows that
  affect a countrys net foreign asset position KFt
• CBt ? KFt
• or KFt KFt-1 CBt

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The capital and financialaccount

• International transactions involving assets,
  either real or financial, are recorded in the
  capital and financial accounts
• The sum of the current balance and the capital
  and financial account add to zero (but there is
  a statistical discrepancy)
• Capital flows correspond to changes in net
  foreign assets held by residents (foreign bonds,
  stocks, real estate, or currency)

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Changes in the net foreignposition of a country

• Net foreign assets are part of a countrys
  national wealth
• The foreign asset position can change in two
  ways
• Acquisition of new foreign assets or liabilities
• Change in the value of existing foreign assets
  and liabilities
• Through asset price changes
• Through exchange rate changes

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Flows and stocks

• We also saw how the current account deficit
  affected the net wealth position of the United
  States
• The question wasIs this worrisome?

Source Economist
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Some reflections on the United States deficit

• Although the United States is the largest debtor
  of the world, it can more easily bear that debt
  than most other countries
• The U.S. economy is strong and growing
• The debt/GDP ratio is still comparably small
• Foreign debt does not necessarily imply the U.S.
  economy to be controlled by foreigners
• The holdings of U.S. debt by foreigners is partly
  voluntary, partly Institutional (central bank
  reserves)
• The relative wealth position can be improved by
  depreciating foreign debt via a devaluation of
  the U.S. dollar

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Reading

• Reading 6-1 Brad Setser et alii, How scary is
  the deficit, Foreign Affairs, July/August 2005
• Reading 6-2 The American economy Wise men at
  ease, The Economist, April 28th 2005
• Reading 6-3 Show me the money, The Economist,
  July 7th 2005

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LDCs remain the largest capital exporter
The current balance of LDCs
billion
Percent
Current balance in percent of GDP(right axis)
Source Worldbank
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International savingand the U.S. deficit

• The strengthening of LDCs, in particular the
  emerging economies in Asia and Latin America
  entail higher world savings
• These savings may not find low-risk investment
  opportunities at home, so they are channeled to
  world capital markets
• Higher world savings will have to be absorbed by
  industrialized countries, and drive the world
  real interest rate downward

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The world interest rateand an industrialized
country
OECD country
World
Real interest rate
S1
r1
r2
I
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Why can OECD countries borrow more easily?

• Industrialized countries draw benefits from
• Greater political stability and lower risks
• High incomes manageable debt/GDP ratios
• A high absorption potential
• Well developed financial markets
• Comparably stable currencies
• Currencies that qualify as international means
  of payment and reserves

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Discussion 6 Capital, Investment, and
International Capital Flows

• What determines savings in the economy?
• What factors are relevant for investment
  decisions?
• What does crowding out mean?
• Can you imagine crowding out at a global scale?
• What would be the main instrument to crowd out?

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