Capital Resources Flashcards
Based on the 3 figures below explain the allocation puzzle and whether it is an investment or a savings puzzle.
By neoclassical growth theory we define the following:
Capital should flow into the countries who TFP catches up relative to the world frontier, and should flow out of the countries who TFP falls behind.
But in real data (Figure 1) we se the opposite result, which is surprising given the theory. Figure one explains the predicted investment and savings relationship between productivity catch up (x-axis) and capital inflows (y-axis). A big group of countries is allocated in the top left kvadrant of the graph, where there is a negative productivity catch up and positive capital inflows, which is the complete opposite case than what the theory tells us.
Empirical work: Gourinchas and Jeanne (2013) show that the allocation of capital flows across developing countries is the opposite of this prediction: capital does not flow more to countries that invest and grow more. We call this puzzle the “allocation puzzle”.
Using a wedge analysis, we find that the pattern of capital flows is driven by national saving: the allocation puzzle is a saving puzzle.
Figure 2 shows after we introduced the investment/capital wedge the neoclassical theory predicted positive relationship between catch up and capital flows. According to the model countries with productivity catch-up should be net recipients of foreign capital and countries falling behind should be net lenders. Therefore does this not help to explain the real data allocation puzzle, where we saw a negative correlation.
On the other hand Figure 3 does help to explain the puzzle. Here the authors introduce a saving wedge, assuming there is a saving distortion such that a country is either subsidizing savings (positive) or taxing savings (negative). Here we se a strong negative correlation in figure 3 between the savings wedge and productivity catch up. So countries that subsidize savings are the ones that catch up while countries taxing savings are the ones who fall behind.
From this article it seems like savings is the important policy tool to catch up, not investment. But why are we then so focused on investment?
Please describe at least two reasons for why savings rates differ across countries,
and briefly explain each of the reasons/implications for development policy?
We have to vies in against each other. The endogenous explanation speaking from the solow model and the exogenous explanation speaking from the life cycle model.
The endogenous explanation: Difference in income across countries
Fact: Savings rates rise with development.
First possible reason: As income rises, so does savings rate (endogenous effect).
- Simple explenation: Under poverty almost everything is consumed. Beyond absolute poverty savings can rise. So poverty is the main reason why savings differ across countries.
The solow model would argue: As capital stock rises, so does y, lowering poverty, which lead to an increase in savings. The solow model fits the OECD countries pretty good, but not other countries.
The exogenous explanation - two examples.
- Life cycle theory: You save for old-age retirement, based on (expected) life-time income.
In “developing countries” the demography is that there are many young people. That would lead to a lot of people saving up for old-age retirement, which would increase growth.
Implication: Faster growth may induce a greater savings ratio.
So “developing countries” and high growth countries may be an explanation on the differens in savings across countries.
- Government savings: Fact: tendency for government savings to be higher in rich compared with poor economies.
So a rich economies the government sector is bigger then in poor, which would possible be an explenation why this countries save more than others.
Please outline and describe the main pros and cons of attracting FDI.
FDI is foreign direct investment, which is one source of capital adding to a countries total investment. FDI is relative small compared to domestic investment, table 10-4 (The book)
Pros
1. increase total investments
2. increase foreign exchange reserves
3. increase tax revenue
4. transfers technology (very important)
Cons
1. Lowers domestic savings - thereby lowering total investment (critical when we just saw that savings was really important).
2. decreases foreign exchange reserves over time
3. no increase in tax revenue because of race to the bottom and transfer pricing
4. No technology transfer but restrain domestic entrepreneurship and innovation.
5. Influence on political decisions (important critic).
Please describe the key FDI knowledge transfer/spillover mechanisms.
FDO knowledge transfer/spillover mechanisms can be divided into horizontal and vertical
Horizontal:
- FDI firms brings with them firm specific assets which include their specialized knowledge or superior technology.
- This technology can not be prevented for spreading out to competing firms in the country. Like throwing a stone in the water, where you are not able to control the waves. In this case trough workers getting a new job and then transferring the knowledge, other business or network copying.
Vertical
Through the supply chan, see drawing in review.
Forward linkage of technology: The foreign firms would want domestic producers to produce more complex inputs. To do this the foreign firms supplies the inputs which make it posible for the domestic firm to produce with higher complexity.
Downward linkage: Foreign firms would by increasing the demand for complex inputs from the domestic firms, increase the domestic firms production of complex inputs to the foring firms production.
Describe the positive and negative mechanisms of vertical FDI spillovers (backward
and forward spillovers)
Horizontal
positive
- Spillovers may take place when local firms improve their efficiency by copying technologies of MNEs either through observation (demonstration effect) or by hiring workers trained by the MNEs (worker mobility). Unambiguous positive effect.
negative
- However, possible negative worker mobility effect as MNEs try to attract the best workers from their competitors. Unambiguous negative effect.
Either positive or negative
- Entry of multilaterals increase competition which forces local firms to use their existing resources more efficiently or to search for new technologies – However,
incentive for MNEs to prevent technology leakage and spillovers from taking place.
Vertical
Forward
Positive:
- (i) Embodied technologies, (ii) Accompanying services, (iii) Competition effects
Negative:
- (i) ‘Lock-in’ to using inputs purchased from MNEs, (ii) Asymmetric bargaining power possible if MNEs gain dominant position upstream
Backward:
positive
* Deliberate knowledge transfer e.g. technical assistance, management experience, quality assurance.
NB! DIRECT linkage not spillover externality – Newman et al (2015)
* Higher requirements for product quality and on-time delivery introduced by MNEs, which provide incentives to domestic suppliers to upgrade their production management or technology.
* MNE entry increasing demand for intermediate products, which allows local suppliers to reap the benefits of scale economies.
Negative
* Asymmetric bargaining power.
* Domestic firms not suited to producing input varieties demanded by foreign firms.
* Increased competition from other MNEs supplying inputs or from imported inputs.
1) Multinational firms are producers of knowledge (assumption about superior capabilities is true)
E.g. China is now ahead of Europe on the field of green solutions, so they will not accept FDI from Europe anymore. They have superior capabilities.
2) Multinational firms transfer knowledge to their overseas operations (new or old technologies?)
3) Foreign affiliates benefit from continuous injections of knowledge from headquarters
4) Productivity spillovers associated with FDI mostly benefit the supplying industries (NB!!!)
- Intra-industry spillovers (horizontal) – None or few effects (worker mobility and spin-offs???)
- Inter-industry spillovers (vertical) – Positive, both backward and forward spillovers, but context dependent
5) FDI inflows facilitate integration into GVCs and affect the composition and the quality of exports
(the link between FDI and economic complexity)
6) Foreign affiliates tend to create good jobs
* FDI and wages
* FDI and worker training -
* FDI and job stability
7) FDI inflows may help improve environmental performance (but also bad cases)
e.g. Most of FDI goes into the mining sector, argue the proffesor.
8) Investment promotion works
Please describe the key FDI knowledge transfer/spillover mechanisms.
The answer should take point of departure in Newman et al (2015), Javorcik (2021) and Lecture 7
Horizontal or intra-sector spillovers: FDI firm has firm-specific asset with a public good characteristic
(e.g. knowledge or superior technology). Cannot prevent it from being transferred to competing firms.
E.g. through worker mobility, copying, business or other networks, etc.
Vertical or inter-sector spillovers: Through the supply chain. Backward: from foreign firms to
domestic input suppliers by increasing demand for specialized inputs. (spillovers to upstream sectors).
Forward: from foreign intermediate input suppliers to domestic producers by increasing the production
of more complex inputs. (spillovers to downstream sectors).
The excellent answer also use the illustration from Lecture 7.
Please discuss the role of domestic savings in a closed developing economy according to the Solow
model. Further, please discuss why the savings rate tends to increase as countries develop.
This answer draws on PRLB ch. 10, p. 374 ff.
In a closed economy, domestic savings is the only source of investments. In the Solow model, an increase
in domestic savings results in an increase in the steady-state level of the capital stock as well as the
steady-state level of income per worker.
Domestic savings in developing countries have two major components, namely private savings (the
largest) and government savings. In developing countries, corporate savings are often small, so we
ignore these.
To understand why savings increase as countries develop, we need to understand why
private savings and government savings increase.
Private savings: The propensity to save for private households can be understood using a life-cycle
model. In this model, households are net savers when they are working. The decision of how much to
save is made based on expected lifetime income. When households retire, they no longer earn income
and spend their savings. This model has two implications for savings as countries develop. First, when developing countries go through the fertility transition as they develop, birth rates go down. This
increases the share of the population who are net savers, which increases the savings rate. Second,
growth will itself increase the savings rate, since this means that those who are currently saving (the
young) expect higher lifetime incomes than those who are currently dissaving (the old).
Government savings: Government revenue tends to rise faster than government consumption during
the development process, which increases the savings rate. However, there is no well-developed theory
to explain either revenue or government consumption.
See review for figure
The figure shows that the average savings rate tends to be higher in richer places. Empirically, the
correlation means that: (i) savings increase prosperity, and/or, (ii) income per capita increases
savings, and/or, (iii) that factors correlated with income per capita also affect savings.
Please, provide theoretical mechanisms that can account for interpretation (i) – (iii).
S/Y –> y
The most basic mechanism is the one familiar from the Solow model. That is, higher savings lead to
higher investments, which increases the capital stock per capita and thus income per capita in the
long run.
Naturally, the 1:1 link between S/Y and I/Y only holds in a closed economy. In an open economy,
featuring perfect capital mobility there need not be any such link in theory. Empirically, real rates of
return appears equalized across countries. Still, at the same time, savings rates and investment rates
are positively correlated across countries in practise.
X –> y and X –> S/Y.
Several mechanisms can be mentioned:
- Richer countries tend have governments that run smaller primary deficits (in the absence of
ricardian equivalence public savings can potentially increase total savings; Ricardian
equivalence seems unlikely in the poorest countries on earth)
- Longevity tends to be greater in richer places. Greater life expectancy may stimulate savings
by making people act “more patient”
- Stronger protection of property rights in richer countries may also mean greater savings.
y –> S/Y
The obvious candidate explanation is that minimum consumption requirements keep savings very
low at low levels of income. As income rises S/Y will therefore increase.
Consider a closed-economy developing country, in which a new source of natural resources is
discovered. Assume that the revenue from the proceeding natural resource extraction accrues to the government. Please discuss which effects one can expect on domestic savings, domestic
investments and domestic growth.
This answer draws on Weil ch. 15 and PRLB ch. 10, p. 374 ff.
The additional revenue can affect capital accumulation to the extent that the increase in government
revenue increases government savings and therefore domestic savings. However, there are several
reasons why this may not happen:
- Government savings may not increase, if increased revenue leads to an overexpansion of the
government sector of the economy (overconsumption), or if the additional revenue is
distributed to favoured groups in the economy (political effects)
- A decrease in private savings may offset the increase in government savings. This
phenomenon, called Ricardian Equivalence, occurs if households expect that the additional
revenue will lead to a tax cut in the future and attempt to smooth consumption by reducing
their current savings.
An additional reason why natural resources may be a “growth curse” rather than a blessing is its
effects on dynamics of industrialization (also known as Dutch disease). A country with natural resource wealth may tend to export natural resources and import a larger share of manufactured
goods for consumption, rather than producing manufactured goods at home. This effect may be
enhanced by an appreciation of the exchange rate (the exchange rate channel is not mentioned in Weil). These effects lead to a lagging manufacturing sector. Since the manufacturing sector has the
most rapid technological process, this means that the country’s long-run growth rate is reduced.
