Equating Real Returns Across Countries

In case you didn't know, the profit motive is powerful. Think about it. Hundreds of millions of people have invested trillions of dollars in pension funds, IRAs, and other assets to provide for their retirement or their children's education or for other reasons. The large banks, mutual funds, and other investment advisors compete for this business by trying to offer their investors a better return than their rivals.

In turn, this means that all these funds put tremendous pressure on the firms that they invest in to earn as much profit as they can.

So, every member of a business management team knows that its survival depends on earning as much profit as possible. If a manager comes along who can earn more profit, she'll get the job. If another firm comes along that can give investors a higher return, it will get the capital funds. The only way to be sure you keep your job or that your company continues to attract the funds it needs to survive is to push profits to their highest possible level — to maximize them.

Profit maximization has a lot of implications. One of these is that firms should invest scarce capital in factories and equipment where the return is highest. If a new factory in Brazil is projected to earn an 18 percent annual return while one in the U.S. is expected to earn 12 percent, build it in Brazil. If it's an even higher 22 percent return in Poland, build it there.

Of course, if everyone starts building factories in Poland, capital will become abundant there and its real return will start to fall. Once it falls to 18 percent, investors will start to build new plants in Brazil. Meanwhile, capital will be flowing out of the U.S. So, the returns will be rising there.

In a full, long-run equilibrium, then, allowing for capital mobility would imply that real returns and hence the real interest rate r would be equalized across the world. This would change our earlier analysis that said a country's real interest rate would depend on its savings rate s. Instead, the real rate would be the same everywhere, and that worldwide real rate would depend on the world supply of savings.

It turns out, however, that capital is not perfectly mobile. So, real returns are not totally equalized across countries. As a result, the savings rate s still plays a critical role in determining the marginal product MP_K and hence the real return on capital r within a country. But the importance of international capital mobility also has to be recognized. To the extent national capital markets are linked, the real return in any one country will very much be influenced by the returns available in others.