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


2

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


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 obtainSP + SG = I


4

Determinants of savings

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

r

S


5

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


6

“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


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


Fiscal positions (1)

11


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

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


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

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


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 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


21

The marginal product of capital

Capital stock

Exp

ecte

d M

PK

MPK


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 / 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


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

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


27

The desired capital stock

Capital stock

Exp

ecte

d M

PK,

and

Ucc

K*

Ucc

MPK


28

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*


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

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*


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

Desired national saving, and desired investment

Rea

l int

eres

t ra

te,

r

Saving, S

Investment, I

E


34

Reading

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


35

Returning to the United States

Source: Economist

In Chapter 2, we discussed the size of the current account deficit of the United States


36

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


37

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


38

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


39

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


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 KF

t

CBt = KFt

or KFt = KF

t-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 liabilitiesThrough asset price changesThrough 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

$ billion

Current balance in percent of GDP(right axis)

Percent

The current balance of LDCs

Source: Worldbank

LDCs remain the largest capital exporter


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

The world interest rateand an industrialized country

r1

World

I

S1

Re

al

inte

rest

rat

e

r2

S2

OECD country

Foreignborrowing


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”?

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