Consider a simple two period model. Under the assumptions of an economy beginning at period 1 with a certain factor endowment of labour and capital with which to produce output( Y=f(k.l)
Assuming that labour and technology are constant and capital has diminishing returns, at any point of time, the economy’s productive capacity is limited by the quantity of scarce productive factors and a fixed level of technology. The output produced in this way in a certain period, can be used to consume products or to invest in capital goods to be used in future. This is how the choice of investment comes into being. However, this is only the supply side of investment.
On the demand side, the country’s inter temporal differences can be indicated using indifference curves. Indifference curves are used to represent consumer preferences for food and clothing, in the general equilibrium model of trade.
Under the assumption of a two time period life, the equilibrium level at which the consumers’ welfare is maximized is where the indifference curve meet the consumption possibility frontier. This is the optimal combination.
However, the above graph applies only to the situation of a closed economy. That is because in such a case, there are no resources or technology to reach consumption combinations that lie outside its consumption possibility frontier. Furthermore, even investment is limited to domestic savings in the above case.
However, according to Van den Berg(2002), if people can use their savings to acquire foreign assets or if they acquire foreign savings by selling assets to foreigners, they may be able to reach inter temporal consumption combinations that lie outside the inter temporal consumption possibility frontier.
In this case, the international interest rate plays a great role in deciding on foreign investments. This is because people, firms, banks, governments and other organizations in a country borrow form savers in another country due to variations in interest rate. Savings will flow from the country with lower interest rate, to that with higher interest rate.
In a simple two period model, the interest rate is determined by the tangency between the inter temporal consumption possibility frontier and the highest attainable indifference curve. Thereby, any differences in interest rates between countries, is the result of dissimilar indifference curves(consumer preferences) or dissimilar inter temporal consumption possibility frontiers(different rates of return to investment).
Dissimilar indifference curves are a result of diversity in people’s
- family responsibilities
- present and expected future wealth and income
- willingness and ability to bear risk
Different returns to investment are a result of availability of factors that can be combined with
- efficiency of the financial system in allocating savings to investors
Economists have used mathematics to model saving and consumption over many periods. Accordingly, an economy will maximize welfare over time by the selection of a series of consumption and saving levels that indicate the economy’s growing production function and inter temporal consumption preferences.
In this multi period model, technological progress, repeated investments, lifetime consumption maximization, savings flow are considered. Accordingly, countries with the greatest potential to growth become net borrowers in the short term.
Countries with slow growing economies and few investment opportunities tend to be net lenders abroad and they run trade surpluses.
Amidst them, rapidly growing economies have an inter temporal comparative advantage. This is because their investments promise greater returns. They also take international investment and unbalanced trade to exploit such inter temporal comparative advantages.
Thereby, the lifetime welfare of people will be higher than in a closed economy when there is inter temporal trade.
Resource credits to Econtutor@Zeecollege