Industrial Structure and Capital Flows - PowerPoint Presentation

1. Industrial Structure and Capital Flows Where is Capital Going and Why? – How Traditional Macro-Theory Fails at Explaining the Reality Author Keyu Jin Presented by Jingyun Cui

2. Overview – What Is This PowerPoint All About?A Typical Theory Building ProcessIntroductionBackgroundPublish!Get the conclusion and send it to some journal editorsWait…What?Something is not explained by the current theoryHow to fix?Think about how to fix the problemDo it!Now it’s the part to actually save this worldWhy?Find out what is causing the problemCheck… a bitDo some analysis to double check the new theoryAuthor did quant analysis and found some empirical material to test her theory OverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

3. Overview – Before We StartSome Helpful Macroeconomics ConceptsOverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary Balance of payments measures all of a country’s transactions with its partner. Current account is one of the two components of a country’s balance of payments, the other being the capital account. Current account consists of the balance of trade, net primary income (net earnings on foreign investments). Current Account and Balance of Payments Convergence effect, also known as the catch-up effect), is the idea that developed countries face diminishing return to capital so that capital will flow from these countries to developing countries.Neoclassical growth theory predicts an increase in the labor force/productivity will leads to a net capital inflow. International Capital Flow

4. Background – What Is Happening Right Now?Mismatch Between Traditional Theory and RealityIntroductionBackgroundThis paper tries to fix this problem!Classical Macro TheoryRealityIncrease in the labor-force or labor productivity in a country induce a net capital inflowCapital flow from developed countries to developing countries“Convergence” effect, which channels capital toward where the effective capital-labor ratio is lowerTrade and financial integration and rapid labor force and labor productivity growth in emerging markets lead to a net capital outflow for these marketsCapital flows from emerging markets to capital-intensive markets“Composition” effect, which offsets the “Convergence” effectOverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

5. Background – Why Is This Happening? (1/2)Where Neoclassical Theory FailsIntroductionBackgroundProblematic theories we are using right nowInaccurate Standard Open-economy Models Untenable Underlying AssumptionMissing Influence of Macro DynamicsUnaddressed Composition EffectThe standard models are the one-good or two-good stochastic growth models of large open economies. These models do not account for factor-proportions trade. Also, their overlapping generations structure are not essential.Standard open-economy models predict net capital inflow into developing countries, which is the opposite of what is happening. This is caused by the fact that they assume that countries cannot engage in intra-temporal commodity trade but only in intertemporal trade. However, large scale forces can alter a country’s structure of trade.Currently, models do not examine the impact of convergence effect and composition effect separately. Such models cannot explain the fact that capital are flowing from emerging markets to economies that become more specialized in capital-intensive sectors.“The conventional analyses of international macroeconomic dynamics on the structure of trade as well as the aggregate feedback effects of trade pattern” while “their interaction can be crucial in determining the global allocation of capital”. OverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

6. Background – Why Is This Happening? (2/2)Where Neoclassical Theory FailsIntroductionBackgroundProblematic theories we are using right nowInaccurate Standard Open-economy Models Untenable Underlying AssumptionMissing Influence of Macro DynamicsUnaddressed Composition EffectThe standard models are the one-good or two-good stochastic growth models of large open economies. These models do not account for factor-proportions trade. Also, their overlapping generations structure are not essential.Standard open-economy models predict net capital inflow into developing countries, which is the opposite of what is happening. This is caused by the fact that they assume that countries cannot engage in intra-temporal commodity trade but only in intertemporal trade. However, large scale forces can alter a country’s structure of trade.Currently, models do not examine the impact of convergence effect and composition effect separately. Such models cannot explain the fact that capital are flowing from emerging markets to economies that become more specialized in capital-intensive sectors.“The conventional analyses of international macroeconomic dynamics on the structure of trade as well as the aggregate feedback effects of trade pattern” while “their interaction can be crucial in determining the global allocation of capital”. OverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

7. Background – How Is Jin Solving These Problems? (1/2)Upgrading the modelIntroductionBackgroundInaccurate modelThe standard open-economy are the one-good or two-good stochastic growth models of large open economies that do not address factor-proportions trade.Current models cannot address the impact of the composition effect.How is Jin Addressing this ProblemDeveloping a stochastic two-country overlapping generations model with production and capital accumulation.Multiple tradable sectors that differ in factor intensity are incorporated to capture factor-proportions-based trade, and financial capital is allowed to flow across borders.Isolate the convergence effect and the composition effect.Analytical tractability. Closed-form solutions can be found.OverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

8. Background – How Is Jin Solving These Problems? (2/2)Addressing the Composition EffectIntroductionBackgroundMissing Composition EffectThe convergence effect and the composition effect co-exist and their combined force determine the tide of capital flow. Current theory focuses only on the standard convergence effect.How is Jin Addressing this ProblemConvergence effect and composition effect coexist.In the integrated framework it’s possible to isolate the convergence effect and the composition effect to examine their disparate impact on capital flows. In the special case, in which the most labor-intensive sector uses only labor as an input to production, isolates the composition effect. Additional assumption is needed to provide closed-form solution under two-country stochastic growth model.OverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

9. Framework – The Model DescriptionSet up the imaginary worldIntroductionBackground412356Earth-500RIntermediate goods are combined to produce a composite good that is used for consumption and investmentEach country uses identical technology to produce intermediate goods I, which are traded freely and costlesslyLabor input consists only of domestic labor, and IGP* firms are subject to country-specific productivity Each country has an overlapping generations economy with young and old consumers. Young consumer supplies one unit of labor while the old only consumeThere are two countries, Home (h) and Foreign (f)Preferences and production technologies are assumed to have the same structure and parameter valueHOMEFOREIGN*IGP firms: Intermediate-goods-producing firmOverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

10. Analysis – Key Factors in the Model (1/13)Part I – Production TechnologiesIntroductionBackgroundMarket ClearingEquilibriumConsumersProduction Technologies Gross production of intermediate good in country :Where K represents capital, A represents labor productivity, and is the labor population. α can be seen as capital intensity measurement.There is also the composite good for Con. and Inv.,Where x donates the amount of good used for investment in that sector of country ; also, summation of equals to 1, and is always greater than 0.  OverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

11. Analysis – Key Factors in the Model (2/13)Part I – Production Technologies IntroductionBackgroundMarket ClearingEquilibriumConsumersProduction TechnologiesBecause all goods can be traded freely, the law of one price holds for all intermediate goods, and their prices can be donated as . Since preferences are symmetric across countries, its associated investment price index isWhich is normalized to 1 for simplicity. Then, we have the capital used in producing goods in country augmented by and . The law of motion for is given by , where is nondecreasing and linearly homogeneous in Where is greater than 0.  OverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

12. Analysis – Key Factors in the Model (3/13)Part I – Production Technologies IntroductionBackgroundMarket ClearingEquilibriumConsumersProduction TechnologiesComparing to the standard capital accumulation equation with adjustment costs,Where is depreciation rate. Our log-linear model and standard model are equivalent up to the second order. Now, let be the price of capital. It is the price, in term of the composite good, of acquiring one unit of capital at the end of the current period to be carried into the next period; it is also the additional needed to augment by one unit. Thus, OverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

13. Analysis – Key Factors in the Model (4/13)Part I – Production Technologies IntroductionBackgroundMarket ClearingEquilibriumConsumersProduction TechnologiesWage rate per unit of labor is given by,And because labor is mobile between sectors within each country. Ultimately, we also want to know the rate of return to capital. By breaking down return into rental earned, which is , and rental earned in the capital adjustment process, which is the marginal contribution of capital in augmenting capital stock for use in the next period times relative price of capital, . Dividing return by price,  OverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

14. Analysis – Key Factors in the Model (5/13)Part II – ConsumersIntroductionBackgroundProduction TechnologiesProduction TechnologiesMarket ClearingEquilibriumConsumers evolves according to,Where is simply an independent random variable.For young consumer who earns wage , and uses his wage both on consumption , and on purchasing capital, Assume consumers consume all resources when old. At , their consumption, which is financed entirely by capital, is ConsumersOverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

15. Analysis – Key Factors in the Model (6/13)Part II – ConsumersIntroductionBackgroundProduction TechnologiesProduction TechnologiesMarket ClearingEquilibriumThe lifetime utility of consumption that a Home consumer born in the beginning of maximizes is,Where denotes discount factor. denote consumption of the young and the old consumer at each time period.The aggregate consumption index in at is,Where represents consumption demand. Consumption price index is as same as the investment price index . ConsumersOverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

16. Analysis – Key Factors in the Model (7/13)Part III – Market ClearingIntroductionBackgroundProduction TechnologiesConsumersProduction TechnologiesConsumersEquilibriumMarket ClearingThe intermediate goods market clear when global demand equals supply. Let denotes output, clearing requiresWhere Let denotes aggregate investment, replacing into output equation, we have,Which shows the relative price of any two goods falls with respect to an increase in the relative output of the two goods with an elasticity When , output changes are offset by price changes so that nominal value of output remain unchanged  OverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

17. Analysis – Key Factors in the Model (8/13)Part III – Market ClearingIntroductionBackgroundProduction TechnologiesConsumersProduction TechnologiesConsumersEquilibriumMarket ClearingNext, domestic labor markets clear when,Because of world resource constraint, we have the total amount of final goods in the world, Where Lastly, GDP can be defined as total consumption and market value of capital stock,  OverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

18. Analysis – Key Factors in the Model (9/13)Key assumption needed for a semi-closed form solutionIntroductionBackgroundAssumption 1Unitary elasticity of substitution of intermediate goods (Θ = 1).Assumption 2Consumers have logarithmic preferences (ρ = 1).Assumption 3The capital-adjustment technology is log-linear, as in equation . All assumptions are important for analytical convenience, and will be relaxed later during the quantitative analysis section.Let’s get back!OverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

19. Analysis – Key Factors in the Model (10/13)Part IV – EquilibriumIntroductionBackgroundProduction TechnologiesConsumersProduction TechnologiesConsumersMarket ClearingConsumersProduction TechnologiesAssuming logarithmic utility, the optimal consumption of a young consumer in is a constant fraction of present value of lifetime resources, which is simply the wage earned by the young. The optimal consumption is therefore,Let be the aggregate consumption of the young cohort. Global consumption is a constant fraction of world labor income . With a unitary elasticity of substitution, is a constant share of world output. Then, the global investment-output ratio is a constant, Where  EquilibriumOverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

20. Analysis – Key Factors in the Model (11/13)Part IV – EquilibriumIntroductionBackgroundProduction TechnologiesConsumersProduction TechnologiesConsumersMarket ClearingConsumersProduction TechnologiesThen, we represent investment in each sector of each country by, Where represent industry-level and country-level investment share of the global investment. LEMMA 1: The share of global investment allocated to industry is a constant where, The greater , the greater investment in industry level.The country-share of global investment in any industry is very important in determining the evolution of a country’s aggregate capital stock and aggregate investment,  EquilibriumOverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

21. Analysis – Key Factors in the Model (12/13)Part IV – EquilibriumIntroductionBackgroundProduction TechnologiesConsumersProduction TechnologiesConsumersMarket ClearingConsumersProduction TechnologiesCountry’s share of global investment can be written as , where,Where is the weighted-average capital share. Investment is not only associated with the size of its expected relative production, captured by , but also with its composition of production. The higher is put on the expected share of future capital-intensive-goods production, the less weight is put on its expected share of labor-intensive-goods production.By contrast, in the one-sector model, is country’s expected present-discounted value of its share of the only good produced globally. A positive, permanent, technology or lobar shock in Foreign, which effectively increases Foreign’s share of global production, would cause a large drop in Home’s share of investment. EquilibriumOverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

22. Analysis – Key Factors in the Model (13/13)Part IV – EquilibriumIntroductionBackgroundProduction TechnologiesConsumersProduction TechnologiesConsumersMarket ClearingConsumersProduction TechnologiesThe total net foreign assets of Home, donates as is the value of Home’s claims on foreigner less the value of foreigner’s claim on Home, Where S is aggregate saving of the young . The current account of Home in period t, denoted as , isFinally, these equation will yield for solution. EquilibriumOverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

23. Analysis – The Composition Effect (1/3)Additional Assumption neededIntroductionBackgroundAssumption 1Unitary elasticity of substitution of intermediate goods (Θ = 1).Assumption 2Consumers have logarithmic preferences (ρ = 1).Assumption 3The capital-adjustment technology is log-linear, as in equation . Assumption 4The most labor-intensive sector uses only labor as an input and no capital in the production technology, i.e., α1 = 0.All assumptions are important for analytical convenience, and will be relaxed later during the quantitative analysis section.Let’s get back!OverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

24. Analysis – The Composition Effect (2/3)Interaction between output and investmentIntroductionBackgroundProposition 1: With Assumption 1-4, the share of Home’s investment in any industry , is a constant and is equal to its initial share of world capital stock in that sector. Combining with & , we have,This means increase in caused by a positive labor force/productivity shock will also leads to an increase in in such a way that more investment is allocated to the country that has a higher initial, weighted-average capital share.  OverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

25. Analysis – The Composition Effect (3/3)Other solutionsIntroductionBackgroundAnother way to understand allocation of saving across countries is by analyzing a country’s supply of saving relative to tis demand for investment. Author shows that because the young who work and earn labor income are the savers in the economy, a country’s supply of savings derives from its capacity to generate labor income. That said, country’s saving to GDP ration at anytime depends on its relative capital-labor ratio. Since,Then,And, OverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

26. Analysis - Quantitative AnalysisExtending into Multi-period OLG settingIntroductionBackgroundHere author extends the analytical two-period OLG framework to a multi-period OLG setting, allowing for an additional nontradable sector. And then use that framework to examine two important global events in the past. She examines what the almost-simultaneous advent of emerging economies implies for international capital flows. Also, increasing labor force in emerging market will have its impact on the current account with the help of factor-proportions trade.Two-period OLG FrameworkMulti-period OLG FrameworkApply to two global eventsOverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

27. Summary and ConclusionIntroductionBackgroundThere is a mismatch between what neo-classical macroeconomic theory predicts and what is really happening Author developed a general-equilibrium framework that integrates a factor-proportions paradigm of trade and financial capital flows, allowing for their interplayThis paper take into account the composition effect, which coexist with the standard, classical convergence effect. Real-world EventsNew FrameworkComposition EffectOverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary

28. Summary and Conclusion Other MaterialsIntroductionBackgroundProductivity Growth and Capital Flows: The Dynamics of Reforms By Francisco J. Buera and Yongseok Shin (2011)“Standard economic theory predicts that capital should flow into countries experiencing a sustained increase in total factor productivity (TFP). The evidence from developing countries over the last three decades contradicts this prediction.”Patterns of International Capital Flows and Productivity Growth: New Evidence By Margaux MacDonald (2015)“Recent evidence from developing and emerging economies shows a negative correlation between growth and net capital inflows, a contradiction to neoclassical growth theory.”OverviewBackgroundWhat is happeningWhy is this happeningHow Is Jin Solving These ProblemsFrameworkAnalysis Key Factors in the ModelThe Composition EffectQuantitative AnalysisSummary