4  The cost of external finance

Financing costs are an important determinant in firms’ decisions to undertake investment projects. Higher real interest rates, for example, reduce the profitability of an investment project because of higher financing costs, and therefore lower the probability of the project being undertaken. This section reviews the cost of finance in a closed economy with perfect information. The analysis is then extended to the open economy and the effects of asymmetric information are discussed.

4.1  Economic growth and the real rate of interest

The Solow-Swan model of long-run economic growth is a useful starting point for discussing the determinants of the cost of external finance and real interest rates. The focus is on real (rather than nominal) interest rates because they more closely reflect the cost of borrowing. This is because real interest rates account for the loss of purchasing power due to inflation. The link between nominal rates, set by financial intermediaries and markets, and real interest rates is through the Fisher equation.[12]

The Solow-Swan model focuses on the long run, i.e. there is no uncertainty or shocks to the economy. Moreover, it abstracts from international borrowing and lending, a fiscal authority and information asymmetries.

There are four variables in the Solow-Swan model: output, capital, labour and knowledge (or effectiveness of labour or labour-augmenting productivity). Capital, labour and labour-augmenting productivity are combined to produce output.[13] Capital accumulation is a function of the depreciation rate of the capital stock and domestic savings. Savings are a fixed fraction of current income, and they equal domestic investment because of the closed economy assumption.[14] The two engines of economic growth in the Solow-Swan model are labour-augmenting productivity and labour force expansion.

In the Solow-Swan model the equilibrium real interest rate (cost of capital) is a function of the depreciation rate of capital, labour-augmenting productivity growth, labour force growth and the savings rate. The equilibrium real rate increases (decreases) when the depreciation rate, productivity and/or labour force growth increase (decrease). The steady state real cost of finance increases (decreases) with declines (increases) in the savings rate.

4.2  The cost of finance in an open economy with perfect information

In a small open economy operating under a flexible exchange rate and with perfect capital mobility, the domestic interest rate is a function of the world interest rate and exchange rate expectations. In a perfect foresight equilibrium (with no government taxation) the domestic nominal interest rate is given by

(1)

where and denote the domestic and world interest rates and is the exchange rate at time t. Equation (1) is derived from the assumption that real rates of return of investment projects are equal across countries, i.e. that savers/lenders are indifferent between holding domestic or foreign assets. This condition is known as uncovered interest rate parity.[15] It implies that if the domestic country has a higher (lower) nominal interest than the rest of the world, because of, for example, higher (lower) inflation or less (more) expansionary monetary policy, its currency is expected to depreciate (appreciate).

With no uncertainty or other distortions, in a small open economy the nominal exchange rate adjusts so as to equalise real rates of return and the cost of borrowing is given by the world real interest rate. The supply and demand of capital in a small open economy is plotted in Figure 1, both as a function of the real interest rate, r. A typical downward sloping demand curve is given by D. The supply curve is infinitely elastic at the real world interest rate, r*, and given by S.

Figure 1 – Supply and demand of capital in a small open economy with perfect information