Q&A Session Week 16

Growth in Open Economy

Our objective is to answer 3 macroeconomic questions related to the effects of
financial openness on GDP per capita :
– Q1 : Does financial openness increase GDP per capital ? Yes iff rc > r ? ; because
GDP per capita (y = Y /N ) is determined by the capital stock per capita (k = K/N )
and the capital stock per capita is higher when r is lower, when r? < r c ⇒ kc < k? and
thus y c < y ? .
– Q2 : Does financial openness accelerate the convergence process ? Yes. To
answer this question, let us assume that r? = rc which implies that y c = y ? in the
long-run. When the country starts with k0 < kc = k? and opens to world capital markets
⇒ the country will receive some capital inflows (the country borrows from abroad) to
bring k0 instantaneously to k? ⇒ countries become richer more rapidly.
– Q3 : Do emerging countries with higher productivity growth experience more
capital inflows than emerging countries with lower productivity growth ? Yes
according to the model predictions. Let us assume that countries X and Z start with
k0 and AZ > AX ⇒ Higher productivity increases the MPK and thus k?,Z > k?,X ⇒
 country Z will receive more capital inflows (country Z should borrow more from
abroad) to bring k0 to k?,Z .
But evidence reveals the opposite : countries with higher productivity borrow less and
even lend to abroad ⇒ We will provide a reason to this in Q&A week 17.
How GDP per capita is determined in a closed economy :
– The production technology in an intensive form (i.e., per capita) is described by :

y = A1−αkα, (1)

where y = Y /N and k = k/N are output and capital per capita, and A is labor
efficiency, and α is the capital intensity of production.
– Objective : Determine y c (superscript c refers to closed economy). Since kc determines
y c , we focus on kc .
– To derive kc , we use the capital market equilibrium which states that : St = It
– Savings St is a fixed fraction s of Yt ⇒ St = sYt .
– Gross investment has two components : It = Kt+1 − Kt + δKt (with δ is the capital
depreciation rate).
– Population grows at rate n : Nt+1 = (1 + n)Nt. Because we consider a steady-state
St It
situation, quantities per capita are constant : Nt
= Nt
.
St Yt
– To derive savings per capita, divide by population : N t
= sN t
= sy ⇒ each agent saves a
fraction s of his/her income.
– Investment at the steady-state. When the economy reaches the steady-state,
Kt+1 Kt Nt+1
kt+1 = kt = k ⇒ Nt+1
= Nt
or Kt+1 = Nt
Kt = (1 + n) Kt ⇒
It = (1 + n) Kt −Kt + δKt = (n + δ) Kt . Investment per capita is
| {z }
Kt+1

It Kt
= (δ + n) ,
Nt Nt
= (δ + n) k. (2)
Kt
Eq. (2) is the investment necessary to keep Nt
= k constant.
– The capital stock per capital, kc , is determined by equality sy = (δ + n) k :

sy = (δ + n) k,
sA1−αkα = (δ + n) k,
sA1−α
= k1−α ,
δ+n
µ ¶1
s 1−α

A = kc. (3)
n+δ
A closed economy is constrained by its savings : when s is small, kc is low.
– Graphical representation of the capital market in the (k, r)-space where r is the interest
rate (a cost for firms but a return for households who rent the capital to firms) :
– KS-curve : minimum amount you require in exchange for each unit of k. Households
stand ready to supply kc on the capital market and thus KS-curve is a vertical line.
– KD-curve : maximum price firms are willing to pay for each unit of k. Max price is
 measured by the return on capital :
∂y
MPK − δ = − δ,
∂k
= A1−α αkα−1 − δ (4)

which is decreasing in k because the production function (1) displays diminishing

returns to capital.
– In equilibrium, households supply kc and firms accept to pay A1−α α(kc)α−1 − δ = rc
Solving for kc :

A1−αα(kc )α−1 = rc + δ = Rc ,
³α´1
c 1−α
k = A . (5)
Rc
When s is small, savings is low, capital cost Rc is high and thus kc is low.
How GDP per capita is determined in an open economy :

– We assume that the country opens its economy to world capital markets
– The access to capital markets implies that the economy is no longer constrained by its
domestic savings.
– To borrow each additional unit of capital, firms must pay r? which is the interest rate
on world capital markets.
– Firms keep on increasing their capital stock per capita until the return on capital
 equalizes the world interest rate :

MPK? − δ = r?,
A1−α α (k)α−1 − δ = r?,
A1−αα (k)α−1 = r? + δ = R? ,
³α´1
? 1−α
k = A , (6)
R?
where R? = r? + δ is the capital cost in open economy.
¡α¢ α

– Plug (6) into the production function (1) to derive output per capita, y? =A. R?
1−α

which depends on A and r? .

– Graphical representation of the capital market in the (k, r)-space when the economy
opens to world capital markets :
– Financial openness does not change the production function and thus does not allow
the economy to circumvent diminishing returns to capital : KD-curve is
downward-sloping.
– The unlimited access to world capital markets (i.e., foreign investors provide any
amount of k as long as they receive r? in exchange for each additional unit) :
KS-curve is a horizontal line in open economy
– If rc > r? ⇒ kc < k? ⇒ y c < y ?

Capital convergence and capital flows :

– Let us assume that rc = r? which implies that kc = k? . The economy starts with k0 .
– An economy is said to experience a capital convergence when this economy starts with
k0 < k? = kc and brings k0 to its long-run level k? = kc .
– In closed economy, it takes time (40 years) to bring k0 to kc since savings increases
gradually : kt+1 − kt = syt − (n + δ) kt > 0.
– The access to world capital markets allows the economy to bring instantaneously k0 to
k? by borrowing from abroad ⇒ the economy converges to the steady-state more
rapidly.
– We say the economy experiences capital inflows defined as the difference between
investment and savings : CI = It − S0 where It is investment at the steady-state and S0
is savings associated with k0 .
– To install k? , firms invest It = (n + δ) Kt.
– Households save sY0 which generate an initial capital-labor ratio, k0.
Technological catch-up and capital flows :
– An economy is said to experience a technological catch-up when an economy starts
with a labor-augmenting productivity of A0 and brings A0 to A? > A0 where A? is the
world productivity frontier (i.e., which collapses to US productivity).
– To show the implications of technological catch-up, we consider two countries, X and
Z, which start with k0. Country X experiences capital convergence (i.e., k0 < k?,X )
while country Z experiences a technological catch-up (together with capital
convergence since k0 < k?,Z ) so that AZ > AX .
– MPK = A1−α αkα−1 is increasing in A. Because AZ > AX ⇒ the return on capital is
higher in country Z than in country X : MPKZ − δ > MPKX − δ.
– The higher return return on capital in country Z shifts the KD-curve to the right and
increases k : k?,Z > k?,X .
– Because both countries start with the same level of k0 and thus have the same level of
savings while country Z must invest more to bring k0 to k?,Z , country Z will experience
higher capital inflows than country X, i.e., CIZ > CIX .