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Capital Market

Capital Market. The Capital Market (Wall Street) Savings and Investment. Firms Borrow: Issue Debt and Equity Governments borrow: Issue Debt. Household’s Receive Income, Consume, and Save: Buy Debt and Equity. Investment. Savings. Capital Market (Wall St.): Determines rates of return

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Capital Market

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  1. Capital Market

  2. The Capital Market (Wall Street)Savings and Investment • Firms Borrow: • Issue Debt and Equity • Governments borrow: • Issue Debt Household’s Receive Income, Consume, and Save: Buy Debt and Equity Investment Savings Capital Market (Wall St.): Determines rates of return Supply of savings = Demand for savings (investment in new capital)

  3. Demand for Capital MPKt+1 Marginal Product of Capital (i.e., MPK) is diminishing in K Kt+1

  4. Demand for Capital • Suppose all firms can borrow at the real interest rate r • Firms invest to the point (d = depreciation rate on capital) r = MPKf(kt+1, nt+1)-d • MPKf refers to the future MPK (the future return to capital) • This margin determines the desired capital stock kt+1

  5. Demand for Investment kt+1=kt*(1-d)+it • Investment this year is capital available next year • kt is the capital stock • it the investment, and • kt+1 is capital stock at the beginning of t+1 Example: • kt = $100 • Depreciation rate = 5% (d = 0.05) • it = $7 • kt+1 = $102

  6. Demand for Capital and Investment rt rt Desired Capital Stock kt+1 determines investment demand id MPKf-d kt+1 it it = kt+1 - kt*(1-d)

  7. Drop in future TFP rt rt • A drop in future TFP reduces MPKf and hence shifts inward the Investment curve Investment Curve MPKf-d kt+1 it

  8. Key Message Education, Openness, Property Rights Protection TFP growth Investment boom, Real GDP growth and Rise in per-capita Income Greater wealth is created

  9. International Allocation of Capital • International capital market equilibrium ensures that for a given country rw= MPKi – d • Return on capital in each country is equal to the common world wide interest rate • Countries with higher TFP will have higher capital per unit of labor • Countries with higher TFP do not, in the long run, offer a higher return to capital

  10. Effects of Risk • What is the effect of a rise in sovereign risk? rw+rp = MPKi – d • rp is the risk premium demanded for investing in country i • As the risk premium rises, there is flight of capital from the country • Thailand, Brazil, Argentina suffered massive outflows of capital • Income and employment drop

  11. Long-Run Labor Market • A rise in employment raises the return to capital • In the long run capital adjusts so that the capital/labor ratio is consistent with the r+d=mpk relation • As capital adjusts, so too does the wage rate • In the long run, wages do not depend on the supply of labor (the labor demand curve is flat) • In the long run, wages only depend on TFP

  12. w n Long-Run Labor Market Equilibrium(k adjusts) • An increase in TFP shifts the MPN curve to MPN*. • The new equilibrium is at point Z with higher real wage and employment. • A shift in labor supply has no effect on the wage in the long run. Z MPN* X MPN Is the wage rate in India low because of the abundance of labor?

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