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Transcript of Goethe Business School Chapter VI: Capital, Investment, and International Capital Flows A. The...
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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 obtainSP + SG = I
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Determinants of savings
Savings depends on The level of income The interest rate Government policies
r
S
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Shifts in the S-curve
r
S
r
S
If income increases, the S-curve shifts to the right
If government outlays increase, the S-curve shifts to the left
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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 rater
I, S
r1
I
S1
r2
S2
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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 < 60% of GDP Annual budget deficit < 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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2,1
3,0
4,0
1,4
1,8
2,6
3,7
3,1 3,0
1998 1999 2000 2001 2002 2003 2004 2005 2006
Contribution ofinvestments
Other contributions
Growth of World GDP
Percentage increase p.a.
Source: Worldbank
Investment and the production cycle
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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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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
Neoclassical investment theory
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 is
equal to the marginal product of capital (MPK) times the price of its final product
R = P MPK = P [F(L,K) / K]or 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
Capital stock
Exp
ecte
d M
PK
MPK
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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 / PK
changes 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
I gross = Inet [MPK - PK /P (r + d)] + K
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The desired capital stock
Capital stock
Exp
ecte
d M
PK,
and
Ucc
K*
Ucc
MPK
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Changes in the desired capital stock (1)
Capital stock
Exp
ecte
d M
PK,
and
Ucc
K1*
Ucc1
MPK
A lowering of the real interest ratewill decrease Ucc and encouragenet investment to expand the desiredcapital stock
Ucc2
K2*
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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)
Capital stock
Exp
ecte
d M
PK,
and
Ucc
K1*
Ucc1
MPK,1
A technological advance willincrease MPK and encouragenet investment to expand the desiredcapital stock
MPK,2
K2*
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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 investment:equilibrium
Desired national saving, and desired investment
Rea
l int
eres
t ra
te,
r
Saving, S
Investment, I
E
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Reading
Abel, Bernanke and Croushore, Chapter 4 (without Appendix)
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Returning to the United States
Source: Economist
In Chapter 2, we discussed the size of the current account deficit of the United States
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US trade (percentages of total)Year-to-Date 2005 March
ExportsCanada 23,6%Mexico 13,1%Japan 6,1%UK 4,4%China 4,2%Germany 3,9%South Korea 3,2%Netherlands 3,1%France 2,7%Taiwan 2,5%Singapore 2,4%Belgium 2,1%Hong Kong 1,8%Australia 1,7%Brazil 1,6%Other 23,6%
ImportsCanada 17,7%China 13,4%Mexiko 10,2%Japan 8,9%Germany 5,2%UK 3,0%South Korea 2,9%Taiwan 2,2%France 2,1%Venezuela 2,0%Italy 1,9%Malaysia 1,8%Ireland 1,8%Brazil 1,5%Saudi Arabia 1,5%Other 23,9%
Source: U.S. Census Bureau
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US Deficit by major trading partner
Source: U.S. Census Bureau
U.S. Deficit by Major CountriesYear-to-Date March 2005
ChinaJapan
CanadaMexico
South KoreaGermany
TaiwanFrance
BrazilUK
-50 -40 -30 -20 -10 0
US $ billion
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2004 Global current account ($ bill. IMF and Roubini/Setzer)
Main deficit countries -783USA -660Australia/New Zealand -36United Kingdom -43Eastern Europe -44
Main surplus countries 783Canada 28Asia (without Japan) 159Japan 154Oil exporters 195Western Europe (without UK) 172Africa and Latin America 12Global residual 63
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Global balance?
Main surplus countries
Canada4%
Asia (without Japan)20%
Japan20%
Oil exporters24%
Western Europe
(without UK)22%
Africa and Latin America
2%
Global residual 8%
Main deficit countries
USA84%
Australia/ New Zealand
5%United
Kingdom5%
Eastern Europe6%
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 country’s net foreign asset position KF
t
CBt = KFt
or KFt = KF
t-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 country’s
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 liabilitiesThrough asset price changesThrough 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 was:Is 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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$ billion
Current balance in percent of GDP(right axis)
Percent
The current balance of LDCs
Source: Worldbank
LDCs remain the largest capital exporter
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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
r1
World
I
S1
Re
al
inte
rest
rat
e
r2
S2
OECD country
Foreignborrowing
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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”?