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>A closed economy can only do 1. And this will require an increase in the rate of interest (or something) to persuade households to postpone consumption.

I'm sorry to diverge from the main point of the post, and I think I've had some of this debate here already but I have difficulty getting past this assumption.

As an individual, I invest to make it through my retirement years. This means that lower interest rates and lower returns means I need to invest more not less.

Lower interest rates make me buy a bigger house, a good that is mostly investment.

Businesses can finance new capital projects more easily in low interest rate environments. The "cost of capital" equation that they use to decide how much to put into investment tells them to invest more in lower rate environment.

On the aggregate, it seems to me that if investment goods have lower returns, that they wear out and depreciate faster, the natural reaction should be to divert more in investment goods and their maintenance just to maintain a reasonable level.

I realize that some forces go the other way. That in lower returns environment, people may not want to put too much resources where they will just be lost, but still... it seems to me the general trend should be the other way.

What am I missing?

Last time I think squirrels were mentioned in this debate.

Benoit: In an overlapping generations model you can sometimes get the result you are talking about (income effects dominating substitution effects, so saving falls when r rises). With a simple infinite horizon (people leave buguests for their kids) representative agent model there are only substitution effects (when r rises, future consumption becomes cheaper relative to present consumption, so we substitute away from present to future consumption). Remember that in a macro model there are really any income effects from price changes, because for every seller there's a buyer, and every borrower a lender, so one is made worse off and the other better off).

I did a post on this once, but can't find it. But I want to avoid saying more about that question here.

I sorta get what you are saying.

With these overlapping generation models, what if there is a large baby boom and in one period there are many workers relative to consumers and the next period after the large generation retires, it's the opposite? Also, what if, in between generations, we run out of a crucial natural resource like oil? What if there is a slow down in technological innovation between the periods? Wouldn't these things lower r and cause more investment relative to consumption in the first period? Are these part of income effects or substitution effects?

I am not so sure he is saying 3 can't happen, but he does note nontradables are 75%, and the adjustment period is long. And if most of the kapital is human, it won't be readily imported. I think it does depend, but the assumption 2 won't dominate in the short term seems highly unlikely.

I am not so sure he is saying 3 can't happen as that it takes time to happen. He does note 75% is in nontradables and the adjustment period is long. One can view 2 as the signal for 3 to happen in the first place. I agree it depends, it is just highly unlikely for 2 not to dominate in the short term under current circumstances of proposed trillion dollar deficits.

In today world, it is perfectly possible kapital transactions, included transactions financed with leasing, which means a temporary import (export) of kapital.

It seems to me that your #1 assumes that the economy is fully deployed, with no spare capacity whatsoever. I think we come to your reasoning when we overlook the potential redeployment and more efficient use of time, labor, materials, and tools.

"A country cannot import investment goods, it can only import consumer goods. "

It seems to me that Krugman is not saying this at all. He is saying the transfer process (the "conversion" of the capital inflow into a flow - net import - of goods) might be ineffective and slow. His blog post is about arguing why a corporate tax cut will not necessarily improve the share of income going to labour in hurry - it might take decades. For the tax cut to have immediate impact on labour incomes, immediate capital goods imports, attracted by the rate of return increase occasioned by the tax increase, would be required. Capital goods imports would proceed until the local rate of return on capital would again equalize with the international rate. The increase in domestic capital stock would reduce the marginal productivity of capital which would then drive down the local rate of return on capital. Krugman's post is all about discussing why an immediate flow of capital goods may not occur.

That's the way I see it anyway.

The other thing that should be said is that he argues that because markets for goods and services are not "perfectly integrated" the the required changes in the real exchange to effect the flow of goods will not be forthcoming in the short term. He doesn't explain "perfectly integrated" - I'm not sure what he means by this - maybe there are still barriers to global trade which detain or limit the adjustment process.

Henry and Lord: fair points. We notice that Purchasing Power Parity does not hold (and therefore real interest rate parity will not hold, if real exchange rates are expected to change). Now why might this be (why aren't markets for goods & services "perfectly integrated")? In this post I have assumed it's because the home and foreign countries produce different goods. But there might be other explanations. A traded/non-traded goods model might be an alternative. Or some sort of transport costs. But I don't think the iceberg model of transport costs will give Paul's results (if transport costs are 5%, then real interest rates are bordered by a 5% differential). One alternative model is where there's some fixed cost to setting up a new export market. I call this the "Sailing Ships" model (ships are costly to build, but sail for free once built). Or maybe there are adjustment costs in changing the mix of goods you produce (so all goods are perfect substitutes in production in the long run, but not in the short run).

It doesn't look as if Krugman has anything specific in mind but your suggestions seem to be the sort of things that might fit the bill. He says in his blog post:

"And because markets for goods and services are still imperfectly integrated - most of GDP isn't tradable at all - it takes large signals......."

So he is saying that "imperfectly integrated" equates with small tradable goods sectors in the world economy. There has been an inertia in developing tradable goods sectors despite the globalization of the last 30 years. This results in a slower adjustment process (which is what his blog post is all about) i.e. the real exchange rate needs larger movements for it to effect adjustment - there is no "immaculate transfer" process.

If you scan some of Krugman's papers on international adjustment, he is never specific about why markets are imperfectly integrated.

Looking at the world as it is, there are bilateral and multilateral trade agreements everywhere. Why are these necessary in a globalized world? Maybe the world trading system isn't as globalized as is made out? Perhaps international factor mobility has a long way to go? (Personally, I think that is a good thing. Globalization has its costs.)

Henry: I tend to agree. But think the degree of immaculatelessness(?) depends on what goods will be transferred. Transfers of machine tools, because of changes in investment, might be fairly smooth. Transfers of haircuts, because of changes in consumption, will be the opposite. (But there might be other examples where investment goods are non-traded, and consumption goods traded.)

I appreciate you are trying to theoretically model, but in a real economy if kapital ROI rises you're starting from a situation of underutilization, in which case there is no kapital/consumption goods tradeoff. In addition, if there is no underutilization, then the expected ROI you measure is in fact likely declining, just mis-expected, which later becomes clear in writeoffs.

john: yes, but it is easier to work through these questions if we assume the central bank is controlling aggregate demand, and will offset any such effects.

Isn't scenario #3 just a combination of #1 and #2? Since we don't care about the eventual ownership of the factories, importing more factories and maintaining the same domestic consumption seems to me much like producing more factories in lieu of apples but importing more banapples instead.

Krugman's core point in the article was about how long it would take for the kapital to actually be built and hence improve the labour share of income. It's obvious that it takes time if the kapital must be built domestically, so his argument isn't contingent on "we can't import machines" as much as "we won't import machines orders-of-magnitude faster than we would have built them domestically."

Nick, great stuff! I'm working on a journal article on this stuff. If I find anything "important," you will be (one of) the first to know about it...

But regarding your post here, for what it's worth, I didn't take Krugman to think that each country produced a different consumption good. You're right, maybe he HAS to be thinking that, deep down, in order to make sense of everything else he wrote, but I don't think he had that in mind. Especially because a big part of his argument is that the tradeable goods sector is small relative to the whole economy, I think he was picturing many consumption goods, only some of which had tolerable shipping costs. (And none of the capital goods could be shipped.)

Bob: Thanks!

On rethinking: yes, I don't think my model is what Paul Krugman has in mind. But I'm not sure what he really has in mind, deep down. And at least my model does give interest rate differentials, in response to some shocks. (As you know, it's the same as the Sraffa interest rate differential.)

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