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The Economics of International Investment

The foreign-investment fuss ignores facts, economics and history.

(The Economist, 1989)

The Goals of this Chapter

- Show how international investment raises the total value of world output and income, and why all countries share in the net gains.
- Explain how international investment permits investors to spread their risk among a greater variety of assets.
- Present evidence and models suggesting that international investment also facilitates the flow of technology between countries.
- Explain why international investment is still small compared to what it could be.

A Two-Period International Investment Model

- The first model presented in this chapter shows how two economies with different time-preferences gain from being able to borrow and lend.
- The model simplifies by assuming that people live for just two periods, which permits us to use a two-dimensional graphic version of the model.
- The model also assumes away the problems of risk and default that normally plague intertemporal transactions.
- This model makes it clear that international trade and international investment are closely related.

The Principal Assumptions of the Two-Period Model:

- Output Y is produced using capital, K, and labor, L, according to the production function Y = F(K,L).
- Output Y can be used for consumption C or as a productive capital good K.
- If the labor force, L, remains constant, investment in new capital is subject to diminishing returns.
- Technology does not change.
- The economy begins period 1 with a certain endowment of labor and capital.
- Suppose, finally, that capital goods last just one period, after which point they must be replaced by newly-produced capital inputs.

Setting Up the The Supply Side of the Model

- Output in period 1, Y1, is a function of the amount of capital produced, K1.
- The two-period intertemporal consumption-possibilities frontier (ICPF) shows that the larger is saving in period 1 (equal to the difference between Y1 and C), the greater is period 2’s output.
- If consumption in period 1 is C”, then saving/investment is Y1 ! C”, and second period output will be Y”2.

Setting Up the The Supply Side of the Model

- On the other hand, if first period consumption is less, say C’, then investment is Y1 ! C’, and second period output will be Y’2.
- Period 2 output and consumption, Y’2 > Y”2 , is greater in this case because (Y1 ! C’) > (Y1 ! C”).
- The curvature of the ICPF reflects diminishing returns to investment; equal additions to investment in period 1 result in smaller and smaller additions to period 2 output .

Setting Up the The Demand Side of the Model

- Intertemporal preferences are represented by intertemporal indifference curves, such as I.
- It is assumed that people only live for two periods, so that they only choose consumption over two periods.
- People always prefer more consumption in both periods to less consumption in both periods; a higher the intertemporal indifference curve, like I’, represents a higher level of total welfare.

Setting Up the The Demand Side of the Model

- At A, the rate at which the economy can substitute period 1 consumption for period 2 consumption equals the rate at which consumers are willing to substitute period 1 consumption for period 2 consumption.
- The slope of the intertemporal price line P is equal to (1+r), where r represents the % premium to induce consumers to voluntarily give up current consumption.
- In intertemporal equilibrium, period 1 consumption c’ enables investment of Y1! c’ create the capital to produce output Y2 = c2 in period 2.

A Two-Period International Investment ModelThe Intertemporal Equilibrium

- A single, isolated economy can do no better than point A.
- However, if people acquire foreign assets or they sell assets to foreigners, they can reach intertemporal consumption combinations that lie outside the ICPF.
- To keep the analysis simple, suppose that the economy is very “small.”

The Intertemporal Equilibrium

- Suppose, finally, that ROW’s interest rate, denoted as r*, is higher than the small economy’s interest rate, r.
- If people in the small country are free to borrow or lend in ROW, they will select the intertemporal consumption pattern given by the point B.
- Consumers are thus able to reach a higher intertemporal indifference curve, which confirms that international investment raises welfare.

The Intertemporal Equilibrium

- The small country’s savers invest hY1 in domestic capital, which creates output 0g in period 2.
- In addition, international investment of jh gives small-country savers a return in period 2 of (1+r*)jh = ge.
- Summing the returns to domestic investment hY1 and international investment jh gives period 2 consumption of 0e.

The Intertemporal Equilibrium

- By being able to lend, export, and import, the small country’s consumers to achieve the combination of period 1 and 2 consumption levels that lie on a higher indifference curve than the best closed-economy consumption point A.
- Notice that for the small country to take advantage of international investment opportunities, it must engage in international trade.
- Notice also that the gains from intertemporal trade require that countries run trade deficits or trade surpluses in the short run; that is, trade deficits or surpluses can be quite desirable and are not necessarily “problems” that need to be corrected.

Determinants of Intertemporal Comparative Advantage

- Differences in interest rates between countries are the result of (1) different indifference curves (consumer preferences) or (2) different ICPFs (different rates of return to investment).
- Differences in intertemporal preferences reflect differences in people’s tastes, age, household responsibilities, present and expected future income, and willingness to bear risk.
- Differences in returns to investment are the result of differences in (1) the availability of other factors to combine with capital, (2) technology, (3) the efficiency of the financial system in allocating savings to investors, and (4) institutions such as the protection of property, the rule of law, contract enforcement, and sound monetary policy.

Many Periods Instead of Just Two Periods

- In multi-period models with technological progress, it remains true that savings will flow to countries where investment or R&D activity promises the highest returns.
- Economies with the greatest growth potential will be net borrowers and have trade deficits in the short run.
- Rapidly growing economies have an intertemporal comparative advantage with their high return investments.
- Economies whose residents, firms, and governments are relatively more frugal will lend to foreigners in the short run and run trade surpluses.
- Both the two-period and multi-period models of international investment show that the lifetime welfare of people is higher than it would be in a closed economy.

A Partial Equilibrium Model of International Savings

- The two-period, two-country intertemporal model of investment and trade does not explicitly tell us who actually enjoys the intertemporal welfare gains and who suffers the potential welfare losses.
- A partial equilibrium model can be used to show how the welfare gains from international investment are distributed among savers and borrowers in one period of time.
- This model is “partial” in nature because it looks at international savings flows in one period; this partial view is ignores the many other savings and trade flows that occur in other periods of time, as suggested by the two-period model.

A Partial Equilibrium Model of International Savings

- In general, the demand curve for savings, or “loanable funds,” is downward sloping to reflect the descending order of the real and financial investment opportunities.
- The supply curve of loanable funds is shown as an upward-sloping curve, suggesting people save more the higher is the interest rate.
- The equilibrium in the market for loanable funds occurs at the interest rate of 10 percent in the Figure.

A Partial Equilibrium Model of International Savings

- Borrowers earn a surplus equal to the area a.

A Partial Equilibrium Model of International Savings

- Borrowers earn a surplus equal to the area a.
- Savers earn a surplus over and above their perceived value of foregone consumption equal to the area b.

A Partial Equilibrium Model of International Savings

- Borrowers earn a surplus equal to the area a.
- Savers earn a surplus over and above their perceived value of foregone consumption equal to the area b.
- The area under the supply of funds curve, area c, represents the opportunity cost of savers’ foregone consumption.

A Partial Equilibrium Model of International Savings

- The area under the supply of funds curve, area c, represents the opportunity cost of savers’ foregone consumption.
- Borrowers earn a surplus equal to the area a.
- Savers earn a surplus over and above their perceived value of foregone consumption equal to the area b.
- The area under D (a+b+c) represents the total returns to the investments on the loanable funds demand curve.

A Two-Country Partial Equilibrium Model of International Investment

- The single country model can be expanded into a two-country model to show how international investment affects lender and borrower surpluses.
- Suppose that the world consists of two countries, India and Pakistan.
- Because of different supply and demand conditions, the rates of return in the two countries are 12 percent and 8 percent, respectively.

A Two-Country Partial Equilibrium Model of International Investment

- In the absence of barriers, savings will move from Pakistan to India.
- The supply curve of funds to purchase assets in India therefore shifts to the right.
- The supply of savings in Pakistan shifts to the left by an equal amount.
- This arbitrage tends to equalize the interest rate in both countries.

The Welfare Effects of International Investment

- Savers in India lose the area a.
- But Indian borrowers find that the lower interest rate provides gains equal to the areas a and b.
- The net gain to Indian citizens is the area b.

The Welfare Effects of International Investment

- Pakistani savers gain areas c and d.
- The area c is not a net gain for the country; it represents returns that were captured by Pakistani borrowers but now accrue to Pakistani savers.
- The net gain to Pakistani citizens is the area d.

The Welfare Effects of International Investment

- Total investment falls in Pakistan by ij and rises in India by fg.
- Pakistan is a net gainer because, by sending savings to India and increasing India’s assets, Pakistan’s savers enjoy higher returns and total Pakistani income rises.

The Gains from Asset Diversification

- Asset holders generally have two goals: (1) maximize returns and (2) minimize risk.
- These two goals often seem to conflict; safer assets generally offer lower returns because wealth holders are more willing to acquire such assets.
- Risk can be reduced by diversifying asset holdings (Don’t put all your eggs in one basket).
- Successful risk reduction requires that asset earnings not be perfectly correlated.
- Since international asset prices and returns are less likely to be correlated, international investment provides opportunities for risk-reducing asset diversification.

Summarizing the Gains from International Investment

- International asset exchanges permit consumers to more efficiently allocate their consumption expenditures over time.
- International asset exchanges permit savings to be channeled to the highest-return investments wherever they may be in the world.
- International investment permits investors to reduce risk by pooling assets from different countries, which are less closely correlated than assets located within a single country.
- These three motives for international investment are often referred to as intertemporal consumption smoothing, the efficient allocation of savings, and risk diversification.

International Investment in the Solow Growth Model

- In the Solow model, the return to investment is the slope of the production function Y = f(K).
- A steep slope implies a high return because each increase in K causes a large increase in output.
- The slope of the production function depends on the stock of capital, the stock of other factors of production, and the level of technology.

The Rate of Return to Investment Depends Jointly on the Capital Stock, Other Factors, and Technology

- Diminishing returns implies that as more capital is added to a fixed amount of other productive resources, each additional unit of capital increases output by smaller and smaller amounts.
- At the lower stock of capital K1, the slope of the production function r1 is greater than the slope r2 at the larger stock of capital K2 (point a versus point b).

The Rate of Return to Investment Depends Jointly on the Capital Stock, Other Factors, and Technology

- The return to capital also depends on the stocks of other factors of production.
- For example, an increase in the amount of labor from L1 to L2 raises the production function from f1(K,L1) to f1(K,L2).
- For a given capital stock K*, the increase in labor causes the marginal rate of return to investment (capital) to rise from r2 to r3 (point c versus point b).

The Rate of Return to Investment Depends Jointly on the Capital Stock, Other Factors, and Technology

- Technological progress shifts the production function, as from f1(K,L1) to f2(K,L1).
- If technological progress causes the slope of f2(K,L1) at K* to be steeper than the slope of f1(K,L1) at K*, the return to investment rises from r2 to r3.

International Investment and Economic Growth

- International investment has been linked to economic growth.
- To understand the possible links, recall the Schumpeterian model of technological progress, summarized as:

q = f( B, r, R, $ ).

- The variable q is the quantity of innovations generated in the economy, R the supply of resources in the economy, B is the profit from innovating, $ the efficiency of R&D activities in terms of the resources necessary to generate an innovation, and r is the interest rate that reflects people’s valuation of future gains versus current income and at which the returns from investments in R&D must be discounted.

International Investment and Economic Growth

- International investment is likely to affect technological progress through B, the profit from innovation.
- Because it contributes to globalization, which is essentially the integration of separate economies into a single world economy, international investment raises the potential profits from innovation.
- International investment can reduce the cost of innovation, $, because it facilitates the flow of ideas.
- There is evidence that foreign direct investment leads to the transfer of technology to the recipient countries, and other forms of investment may also facilitate information flows between economies, thereby reducing $.
- Foreign investment may also stimulate innovation be increasing competition.

Why Is International Investment So Small?

- Investment is subject to some degree of risk.
- Investment is an intertemporal transaction where one party agrees to accept payment(s) at some future date.
- It is impossible to foresee the future with certainty.
- There are also some perverse incentives that increase the likelihood that future payments will fall short of agreed-to levels.
- International investment faces greater difficulties in foreseeing the future and countering perverse incentives.

Why Is International Investment So Small?

- Information available to lenders and borrowers is often asymmetric, with lenders knowing less than borrowers about the eventual payout of assets.
- Asymmetric information can result in adverse selection, which is the case where, because buyers have difficulty in verifying the quality of assets, a disproportionate amount of “bad” assets are likely to be offered for sale.
- Moral hazard refers to the likelihood that once borrowers have acquired a loan, sold stock, or sold a bond, they will behave differently than they would had they not gained the financing, thereby reducing the eventual earnings from an asset.

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