Chapter VI: Capital, Investment,
and International Capital Flows
A.
B.
C.
D.
The determinants of savings
The investment decision
Marginal product of capital and user
costs of capital
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
r
S
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Shifts in the S-curve
If income increases,
the S-curve shifts to
the right
r
If government outlays
increase, the S-curve
shifts to the left
r
S
S
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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
r
S2
S1
r2
r1
I
I, S
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Crowding out and the
Maastricht “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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Investment and
the production cycle
Percentage increase p.a.
4,0
Contribution of
investments
Growth of
World GDP
3,7
3,0
3,1
3,0
2005
2006
2,6
2,1
1,8
1,4
Other contributions
1998
1999
2000
2001
2002
2003
2004
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 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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Expected MPK
The marginal product
of capital
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
Ucc = i PK + d PK - PK
= PK (i + d - PK / PK )

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
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Fisher-Gleichung



We assume that PK / PK
changes with the general rate
of 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 Fisher
1867-1947
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Determining the desired
capital 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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Expected MPK, and Ucc
The desired capital stock
Ucc
MPK
K*
Capital stock
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Expected MPK, and Ucc
Changes in the desired
capital stock (1)
A lowering of the real interest rate
will decrease Ucc and encourage
net investment to expand the desired
capital stock
Ucc1
Ucc2
MPK
K1* K2*
Capital stock
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User cost of capital in the
global 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 will
increase MPK and encourage
net investment to expand the desired
capital stock
Ucc1
MPK,2
MPK,1
K1*
K2*
Capital stock
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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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Real interest rate, r
Savings and investment:
equilibrium
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
In Chapter 2,
we discussed the size
of the current account
deficit of the United
States
Source: Economist
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US trade (percentages of total)
Year-to-Date 2005 March
Exports
Canada
Mexico
Japan
UK
China
Germany
South Korea
Netherlands
France
Taiwan
Singapore
Belgium
Hong Kong
Australia
Brazil
Other
Imports
23,6%
13,1%
6,1%
4,4%
4,2%
3,9%
3,2%
3,1%
2,7%
2,5%
2,4%
2,1%
1,8%
1,7%
1,6%
23,6%
Source: U.S. Census Bureau
Canada
China
Mexiko
Japan
Germany
UK
South Korea
Taiwan
France
Venezuela
Italy
Malaysia
Ireland
Brazil
Saudi Arabia
Other
17,7%
13,4%
10,2%
8,9%
5,2%
3,0%
2,9%
2,2%
2,1%
2,0%
1,9%
1,8%
1,8%
1,5%
1,5%
23,9%
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US Deficit
by major trading partner
U.S. Deficit by Major Countries
Year-to-Date March 2005
UK
Brazil
France
Taiwan
Germany
South Korea
Mexico
Canada
Japan
China
-50
-40
-30
-20
-10
0
US $ billion
Source: U.S. Census Bureau
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2004 Global current account
($ bill. IMF and Roubini/Setzer)
Main deficit countries
USA
Australia/New Zealand
United Kingdom
Eastern Europe
Main surplus countries
Canada
Asia (without Japan)
Japan
Oil exporters
Western Europe (without UK)
Africa and Latin America
Global residual
-783
-660
-36
-43
-44
783
28
159
154
195
172
12
63
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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 country’s net foreign
asset position KFt
CBt =  KFt
or KFt = KFt-1 + CBt
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The capital and financial
account



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 foreign
position 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
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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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LDCs remain
the largest capital exporter
The current balance of LDCs
Percent
$ billion
Current balance
in percent of GDP
(right axis)
Source: Worldbank
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International saving
and 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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Real
interest rate
The world interest rate
and an industrialized country
World
OECD country
S1
S2
r1
r2
I
Foreign
borrowing
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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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