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Trend Capital when Goods and Capital Market Frictions Exist

Valerie Vandermeulen and Werner Roeger

No 145, European Economy - Discussion Papers from Directorate General Economic and Financial Affairs (DG ECFIN), European Commission

Abstract: In the aftermath of the financial crisis, it had become clear the Euro Area was suffering from insufficient investment. Actual capital stock was below benchmark capital, the amount of capital you need to support trend labour and total factor productivity (TFP) growth rates. The current COVID-19 pandemic might enlarge the gap between benchmark and actual capital, since both the private and public sector are facing limitations to invest. In the current paper, benchmark capital is estimated based on trend supply side conditions and trend in capital and goods market frictions, to investigate whether such a gap exists in the Euro Area and the US and how it has evolved over time. The paper is based on the European Commission’s production function method and uses trend labour supply and TFP as basis for trend supply side conditions. The first order condition of the Cobb-Douglas production function are used to calculate goods market and capital market frictions. Capital costs are estimated using world interest rate as a rental price of capital, adjusted for depreciation, taxes and relative investment prices. In the past, benchmark capital was driven by strong growth in supply side factors, but since trend labour and TFP growth rates have declined, capital and goods market frictions are becoming more important in explaining benchmark capital growth. The paper shows that after the 2008 crisis, a gap occurred between benchmark capital and actual capital. As of 2012, the gap started to close, but benchmark capital growth was very low in the Euro Area, much below that of the US. Just before the current 2020 crisis, the capital gap was closed in the Euro Area and was positive in the US, but it is expected that actual capital growth might stop again due to the limitations to private and public investment.

JEL-codes: D1 D2 D3 E6 H2 H21 J08 J2 (search for similar items in EconPapers)
Pages: 36 pages
Date: 2021-07
New Economics Papers: this item is included in nep-eec, nep-fdg, nep-isf, nep-lma and nep-mac
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