Chapter VI: Capital, Investment, and International Capital Flows

1. 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

2. The capital market Householdsreceive income, consume and save: Buy debt and equity Firmsissue debt, equity Governments issue debt Savings Investment Capital Market

3. 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

4. r S Determinants of savings • Savings depends on • The level of income • The interest rate • Government policies

5. r r S S 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

6. r S2 S1 r2 r1 I I, S “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

7. 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

8. 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)

9. The market for EMU government bonds

10. 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

11. Fiscal positions (1)

12. Fiscal positions (2)

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

14. 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

15. 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

16. Growth of World GDP Contribution ofinvestments Other contributions Investment and the production cycle Percentage increase p.a. Source: Worldbank

17. 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

18. 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

19. 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

20. 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 productR = 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

21. The marginal product of capital Expected MPK MPK Capital stock

22. 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.

23. 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 )

24. 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

25. 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

26. I gross = Inet [MPK - PK /P  (r + d)] + K Investment function • Net investment is therefore: K = I net = Inet [MPK - PK/P  (r + d)] • And including replacement investment we obtain

27. The desired capital stock Expected MPK, and Ucc Ucc MPK Capital stock K*

28. Ucc2 K2* 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*

29. 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

30. 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

31. MPK,2 K2* 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*

32. 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

33. Savings and investment:equilibrium Real interest rate, r Saving, S E Investment, I Desired national saving, and desired investment

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

35. In Chapter 2, we discussed the size of the current account deficit of the United States Returning to the United States Source: Economist

36. US trade (percentages of total)Year-to-Date 2005 March Source: U.S. Census Bureau

37. US Deficit by major trading partner Source: U.S. Census Bureau

38. 2004 Global current account ($ bill. IMF and Roubini/Setzer)

39. Global balance? IMF and Roubini/Setzer

40. 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 KFt • CBt =  KFt • or KFt = KFt-1 + CBt

41. 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)

42. 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 liabilities • Through asset price changes • Through exchange rate changes

43. 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

44. 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

45. 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

46. LDCs remain the largest capital exporter The current balance of LDCs $ billion Percent Current balance in percent of GDP(right axis) Source: Worldbank

47. 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

48. S2 Foreignborrowing The world interest rateand an industrialized country OECD country World Real interest rate S1 r1 r2 I

49. 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

50. 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”?