1. 1 Capital Market

2. 2 The Capital Market (Wall Street) Savings and Investment Household’s Receive Income, Consume, and Save: Buy Debt and Equity Firms Borrow: Issue Debt and Equity Governments borrow: Issue Debt Capital Market (Wall St.): Determines rates of return Supply of savings = Demand for savings (investment in new capital) Savings Investment

3. 3 Demand for Capital Marginal Product of Capital (i.e., MPK) is diminishing in K MPK t+1 K t+1

4. 4 Demand for Capital Suppose all firms can borrow at the real interest rate r Firms invest to the point (d = depreciation rate on capital) r = MPK f (k t+1, n t+1 )-d MPK f refers to the future MPK (the future return to capital) This margin determines the desired capital stock k t+1

5. 5 Demand for Investment Investment this year is capital available next year k t is the capital stock i t the investment, and k t+1 is capital stock at the beginning of t+1 Example: –k t = $100 –Depreciation rate = 5% (d = 0.05) –i t = $7 –k t+1 = $102 k t+1 =k t *(1-d)+i t

6. 6 Demand for Capital and Investment Desired Capital Stock k t+1 determines investment demand itit idid rtrt MPK f -d rtrt i t = k t+1 - k t *(1-d) k t+1

7. 7 Drop in future TFP itit Investment Curve rtrt MPK f -d rtrt A drop in future TFP reduces MPK f and hence shifts inward the Investment curve k t+1

8. 8 Key Message Education, Openness, Property Rights Protection TFP growth Investment boom, Real GDP growth and Rise in per-capita Income Greater wealth is created

9. 9 International Allocation of Capital International capital market equilibrium ensures that for a given country r w = MPK i – d Return on capital in each country is equal to the common world wide interest rate Countries with higher TFP will have higher capital per unit of labor Countries with higher TFP do not, in the long run, offer a higher return to capital

10. 10

11. 11 Effects of Risk What is the effect of a rise in sovereign risk? r w +r p = MPK i – d r p is the risk premium demanded for investing in country i As the risk premium rises, there is flight of capital from the country Thailand, Brazil, Argentina suffered massive outflows of capital Income and employment drop

12. 12 Long-Run Labor Market 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+d=mpk 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

13. 13 Long-Run Labor Market Equilibrium (k adjusts) 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. MPN* MPN w n X Z Is the wage rate in India low because of the abundance of labor?