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Global Allocation of Capital

Global Allocation of Capital. 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.):

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Global Allocation of Capital

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  1. Global Allocation of Capital

  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. Diminishing Marginal Productivity of Capital MPK Fix A, n • MPK depends on A and k/n • For given n and A, a rise in k leads to a fall in MPK k

  4. Demand for Capital MPK-d • Suppose all firms can borrow at the real interest rate rw • Suppose capital depreciates at the rate d • Firms invest to the point where rw = MPK(A,k*/n)-d • The current capital stock is pre-determined • This margin determines the desired capital stock kt+1 cost of capital = rw MPK(A,k/n)-d k* k A country acquires capital until the return to capital net of depreciation (MPK-d) equals the cost of capital rw

  5. International Allocation of Capital r MPK(Alow,k/n)-d • Two countries: Alow and Ahigh • Does Ahigh offer a higher return to capital in the long run? • No • The country with Ahigh will acquire more capital up until the point that rates of return are equalized. • Both higher A and higher k lead to higher GDP MPK(Ahigh,k/n)-d rw=MPK-d klow khigh k Investors allocate capital to seek the highest return. Consequently, in equilibrium, all countries (abstracting from risk) offer the same return to capital on the margin.

  6. Capital by Country, 2004 Source: Caselli and Feyrer, “The Marginal Product of Capital,” Quarterly Journal of Economics, 2007

  7. MPK by Country, 2004 MPK Source: Caselli and Feyrer, “The Marginal Product of Capital,” Quarterly Journal of Economics, 2007

  8. Demand for Investment kt+1=kt*(1-d)+it • Investment this year is capital available next year • kt is the current (pre-determined) capital stock • it is the level of investment, and • kt+1 is the capital stock at the beginning of t+1 Example: • t = 1970 • kt = $100 (the amount of capital used to produce GDP during 1970) • Depreciation rate = 5% (d = 0.05) • it = $7 (the amount of investment during 1970) • kt+1 = 100*.95+7 = $102 (the amount of capital for 1971)

  9. Demand for Investment it = kt+1 - kt*(1-d) r r Investment demand is determined by a change in the desired capital stock rw id MPKt-d MPKt+1-d i kt kt+1 k it = kt+1 - kt*(1-d) change in capital

  10. TFP, Capital, and Investment The level of capital (or the capital-GDP ratio) is determined by the level of TFPThe investment rate (the ratio of investment to GDP) is determined by the rate of change of TFP

  11. Investment and Growth

  12. 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, investment slows down in a country • Thailand, Brazil, Argentina suffered massive outflows of capital • Income and employment drop

  13. Investment and Uncertainty The rise in the risk premium following a financial crisis contributes to a collapse in investment

  14. Long-Run Labor Market(capital adjusts to a rise in labor supply) • Suppose the supply of labor rises for exogenous reasons • 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 = MPK - d 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

  15. w n Long-Run Labor Market Equilibrium(capital adjusts to a rise in TFP) • 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?

  16. Key Message Greater wealth is created Investment boom, GDP growth TFP growth Good Institutions: Education, Openness, Property Rights Protection

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