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## Foreign Direct Investment

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**Question for Today:Why does investment capital flow from**some economies to others?**Why Does Capital Flow?**According to optimal investment analysis... Whenever returns are different in two countries. According to the Balance of Payments Equation... It doesn’t have much choice. That is, it must flow into any country that is investing more than it is saving.**The MacDougall Diagramof International Investment Flows**Model for understanding the interaction of supply of and demand for investment capital in different countries. Provides us with a benchmark for interpreting cross-border capital movements. Simple but quite useful**Optimal International Investment**x-axis measures total capital available for investment in a country O Capital**Optimal International Investment**y-axis reflects the prevailing rate of return per unit of capital (i.e. per $) available in a country. r (rate of return) O Capital**Optimal International Investment**Then draw a line which reflects the prevailing rate of return in an economy, depending on the total stock of capital. r (rate of return) O Capital**Optimal International Investment**Why does the line slope downward? r (rate of return) O Capital**Optimal International Investment**If a country only has one unit of capital, the rate of return must be high. r (rate of return) O Capital**Optimal International Investment**If a country only has one unit of capital, the rate of return must be high. r (rate of return) Lots of land, lots of workers, little equipment, few factories. O Capital**Optimal International Investment**r (rate of return) As more capital is around competing, land becomes scarce and workers become expensive. O Capital**Optimal International Investment**r (rate of return) If k is the total stock of capital in a particular country O Capital k**Optimal International Investment**r (rate of return) Then r0 is the prevailing interest rate in the economy. r0 O Capital k**Optimal International Investment**r (rate of return) The shaded area then represents the economy’s gross domestic product (GDP). r0 O Capital k**Optimal International Investment**Now consider a second country with a different (better) schedule of return possibilities... r (rate of return) O Capital k**Optimal International Investment**Now consider a second country with a different (better) schedule of return possibilities... r (rate of return) O Capital k**Optimal International Investment**a lower supply of capital... r (rate of return) O k k Capital**Optimal International Investment**a lower supply of capital... r (rate of return) O k Capital**Optimal International Investment**and therefore a higher prevailing interest rate. r (rate of return) r0 O k Capital**Optimal International Investment**r (rate of return) Denoting variables of this second (call it ‘foreign’) country with asterisk. r0* O* k* Capital**We then can take this graph and flip it around.**r (rate of return) r0* O* k* Capital**We then can take this graph and flip it around.**r (rate of return) r0* O* Capital k***Then add the graph of the original country (home country).**r (rate of return) r0* O* Capital k k***How far over do we bring it?**r (rate of return) r0* r0 O O* Capital k k***Until the length of the horizontal axis represents the total**quantity of capital in the two economies... r (rate of return) r0* r0 O O* Capital k k***So that the length from 0 to k0 is the amount of capital in**the domestic economy... r (rate of return) r0* r0 O O* Capital k0**So that the length from 0* to k0 is the amount of capital in**the foreign economy... r (rate of return) r0* r0 O O* Capital k0**Now what happens if both countries allow capital to flow**freely between them? r (rate of return) r0* r0 O O* Capital k0**The owners of capital in the home country are only earning**r0 r (rate of return) r0* r0 O O* Capital k0**Whereas capital in the foreign country is earning a higher**return of r0* r (rate of return) r0* r0 O O* Capital k0**So owners of capital in the home country will begin to move**capital overseas... r (rate of return) r0* r0 O O* Capital k0**Shifting k to the left**r (rate of return) r0* r1* r1 r0 O O* Capital k1 k0**Increasing the supply of capital in the foreign country**r (rate of return) r0* r1* r1 r0 O O* Capital k1 k0**Decreasing the supply of capital in the home country**r (rate of return) r0* r1* r1 r0 O O* Capital k1 k0**Increasing interest rates in the home country**r (rate of return) r0* r1* r1 r0 O O* Capital k1 k0**And decreasing the returns to capital in the foreign country**r (rate of return) r0* r1* r1 r0 O O* Capital k1 k0**When will the flows of capital from the home to the foreign**country cease? r (rate of return) r0* r1* r1 r0 O O* Capital k1 k0**When incentives to transfer capital no longer exist...**r (rate of return) r0* r1* r1 r0 O O* Capital k1 k0**When rates of return to capital are equated: when r1 = r1***r (rate of return) r0* r1* r1 r0 O O* Capital k1 k0**This concept is know as:**Real Interest Parity r (rate of return) r0* r1* r1 r0 O O* Capital k1 k0**Example: Japan 1980**Japan has severe capital controls in place. Japanese investors are largely restricted from holding foreign assets. Returns in rest of the world - especially high interest rates in U.S. - appear attractive to Japanese. Japan has $11 billion in net inflows.**Japan in 1980.**r (rate of return) r0* r0 O O* Capital k0**Example: Japan 1980**In December, Japan passes Foreign Exchange and Foreign Trade Control Law. Large pool of savings Japan has built up over the years slosh onto world capital markets. Japanese $11 billion inflows become $21 billion in outflows by 1983 and $87 billion by 1987.**The foreign country’s GDP increases from this...**r (rate of return) r0* r1* r1 r0 O O* Capital k1 k0**to this.**r (rate of return) r0* r1* r1 r0 O O* Capital k1 k0**The home country loses some GDP...**r (rate of return) r0* r1* r1 r0 O O* Capital k1 k0**The home country loses some GDP...**r (rate of return) r0* r1* r1 r0 O O* Capital k1 k0**But total world production has now increased by this amount.**r (rate of return) r0* r1* r1 r0 O O* Capital k1 k0**For use of the home country’s capital, the foreign country**pays r1* times the amount borrowed. r (rate of return) r0* r1* r1 r0 O O* Capital k1 k0