Capital Flow in Open Economy: Growth Week 17 Q&A

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Questions and Answers

What is the main reason why Asian countries experience capital outflows instead of capital inflows?

Asian countries have low productivity growth, leading to low returns on capital.

Asian countries have high taxes on capital, reducing the return on investment.

Asian countries have high investment but even higher savings, resulting in capital outflows. (correct)

Asian countries have low-quality institutions that reduce the return on capital.

How do Asian countries subsidize savings and reduce present consumption?

By implementing high taxes on capital to discourage investment.

By having institutions of low quality that reduce the return on capital.

By maintaining a low level of consumption (C) relative to their high investment (I). (correct)

By experiencing low productivity growth and a low return on capital.

What is the 'allocation puzzle' referred to in the text?

The puzzle of why Asian countries have high investment but even higher savings, resulting in capital outflows. (correct)

The puzzle of why Asian countries have low-quality institutions that reduce the return on capital.

The puzzle of why Asian countries have high taxes on capital, leading to capital outflows.

The puzzle of why Asian countries experience high productivity growth despite capital outflows.

What is the relationship between the marginal product of capital (MPK) and capital inflows in Asian countries?

MPK is high in Asian countries, leading to capital outflows. Signup and view all the answers

What is the role of savings subsidies in explaining the capital outflows in Asian countries?

Savings subsidies in Asian countries shift the savings curve to the right more than the investment curve, leading to capital outflows. Signup and view all the answers

What is the relationship between the technological catch-up of Asian countries and their capital outflows?

Technological catch-up in Asian countries leads to higher savings and capital outflows. Signup and view all the answers

According to the open economy Solow growth model, what should happen to capital flows in emerging countries experiencing rapid productivity growth?

They should experience capital inflows Signup and view all the answers

The evidence presented contradicts the prediction of the open economy Solow model regarding:

The relationship between productivity growth and capital inflows Signup and view all the answers

What is a possible explanation for the Capital Allocation Puzzle according to the text?

Rich countries have higher labor productivity than assumed Signup and view all the answers

Under perfect capital mobility and diminishing returns to capital, capital should flow:

From rich to poor countries Signup and view all the answers

What happens to the marginal product of capital as the capital stock increases, according to the text?

It decreases due to diminishing returns Signup and view all the answers

In the balance of payments accounting, what would a sustained capital inflow from abroad correspond to?

A current account deficit Signup and view all the answers

If the interest rate in the UK increases, how will this affect the demand for US dollars and the exchange rate in a floating exchange rate regime?

The demand for US dollars will increase, leading to an appreciation of the US dollar Signup and view all the answers

In a fixed exchange rate regime, if there is an increase in the demand for US dollars, how will the central bank intervene?

The central bank will sell pounds and buy US dollars to increase the supply of US dollars Signup and view all the answers

According to the uncovered interest parity condition (UIPC), if the expected future exchange rate is higher than the current exchange rate, what can be inferred about the relative interest rates?

The domestic interest rate is lower than the foreign interest rate Signup and view all the answers

In a world of perfect capital mobility, what condition must hold for investors to be indifferent between investing domestically or abroad?

The expected returns on domestic and foreign assets must be equal when denominated in the same currency Signup and view all the answers

If the expected future exchange rate is lower than the current exchange rate, what can be inferred about the relative returns on domestic and foreign assets?

The return on domestic assets is higher than the return on foreign assets Signup and view all the answers

In the context of the uncovered interest parity condition (UIPC), what does the term 'uncovered' refer to?

The absence of any foreign exchange risk hedging Signup and view all the answers

Study Notes

Exchange Rates and Investments

An increase in UK interest rates (rUK) makes UK assets more profitable, encouraging US to purchase more UK assets, shifting the QS,$ curve to the right, and putting downward pressure on the exchange rate (e).
In a floating exchange rate system, the appreciation of the exchange rate (e) decreases from e0 to e1.
In a fixed exchange rate regime, the central bank (CB) sells £ and purchases $ to avoid an appreciation of the exchange rate, neutralizing the exchange depreciation (ED) for £.

Unbiased Interest Rate Parity Condition (UIPC)

UIPC derivation: an investor with 1 £ decides whether to invest domestically or abroad (e.g., in the US).
1 £ invested in a UK asset returns (1 + r) £ after one year, while 1 £ invested in a US asset returns 1 e (1 + r?) £ after one year.
In a world of perfect capital mobility, returns on financial investments should be equalized across countries: (1 + r?)ea = 1 + r.

Capital Allocation Puzzle

The puzzle: Asian countries experience capital outflows despite high productivity growth, contradicting the expectation of capital inflows.
Solving the puzzle: Asian countries may have institutions of low quality, reducing the return on capital, or they subsidize savings, shifting the KS-curve to the right.

Savings Subsidy and Capital Outflows

Asian countries subsidize savings by keeping consumption (C) low, leading to capital outflows (CIt = It − St < 0).
This subsidy is a result of the willingness to promote growth by increasing exports and reducing imports.

Why Capital Does Not Flow from Rich to Poor Countries

Evidence shows that capital tends to flow from emerging to rich countries, contradicting the expectation of capital flowing from rich to poor countries.
The reason is that rich countries have a higher labor productivity, making rR > rP.

Capital Allocation Puzzle and Technological Catch-up

An economy experiences a technological catch-up when it brings its labor-augmenting productivity (A0) to the world productivity frontier (A?).
Predictions of the open economy version of the Solow growth model: emerging countries with higher productivity growth should receive more capital inflows.
However, evidence contradicts this theory, with capital flowing from emerging to rich countries.

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Description

Explore the reasons why capital does not flow from rich to poor countries in an open economy scenario. Analyze the impact of production functions, diminishing returns to capital, and evidence on capital flow patterns.