Economists have argued that the relative price of capital goods, especially machinery and equipment, is a key determinant of investment and growth (Restuccia and Urrutia 2001, Jones 1994, Sarel 1995, Lee 1995, DeLong and Summers 1991, 1993). The price of capital goods – relative to consumption – is much higher in poor countries, and this was considered to be fundamental when explaining the lower investment rates, living standards and growth in these economies.
There is less consensus what causes cross-country heterogeneity in the relative price of capital goods. Some have argued that it reflects differences in countries’ productivity in the making of machinery and equipment, or other tradable goods to exchange for them (Hsieh and Klenow 2007). Others link it to distortionary policy choices, such as trade barriers in the capital goods sector (Eaton and Kortum 2001, Sposi 2015). Research into cross-country differences in relative capital goods prices has blossomed, but those researchers have largely neglected the changes over time in these relative prices within countries.
In our recent research (IMF 2019), we have revisited the debate on what drives the relative price of investment and its macroeconomic implications, using the dramatic changes in prices that have recently taken place across countries and sectors. Using sector-level producer price data, we were able to show that reductions in distortionary trade policies and improvements in productivity both contributed to the decline in the relative prices of capital goods. Analysis of country- and sector-level data shows that lower relative prices of capital goods have boosted real investment across countries, as DeLong and Summers (1991), among others, have hypothesised.
Rising trade tensions and sluggish productivity growth are likely to slow the decline in the relative price of investment goods, which would hold back real investment growth. We think that we should give renewed attention to this relatively unexplored channel, through which the slowing pace of trade integration – or its potential reversal – can affect future economic prospects.
The stylised facts
Since 1990, the price of machinery and equipment relative to the price of consumption fell about 60% in advanced economies and about 40% in emerging market and developing economies (Figure 1).
Figure 1 Dynamics of relative prices across types of capital goods and broad country groups
(percent change relative to 1990)
Sources: Penn World Table 9.0 and IMF staff calculations.
Notes: The figure shows the percentage change from the relative investment prices in 1990. The solid lines plot year fixed effects from a regression of low relative prices on year fixed effects and country fixed effects to control for entry and exit during the sample period and level differences in relative prices. AE = advanced economies; EMDE = emerging market and developing economies.
The fall in the relative price of computing equipment, which has declined about 90% since 1990 (based on KLEMS data, primarily from advanced countries), is most striking. Overall these were dramatic declines, especially when compared with the price of housing and commercial structures. These mostly rose in price at the same rate as consumption, or even faster in advanced economies. Other investment (R&D, for example) and transport equipment also declined in relative prices over time, but this decrease was smaller.
Figure 2 suggests that relative price decreases coincided with significant increases in the real investment rate in machinery and equipment. Over the last 50 years, real investment in machinery and equipment has been steadily rising, especially in emerging market and developing economies. Since 1990, real investment in machinery and equipment as a share of real GDP has risen from 3% to 6%, contributing to much-needed capital deepening in these economies.
Figure 2 Real investment rate, and changes in the relative price, of machinery and equipment (%)
Sources: Penn World Table 9.0; IMF World Economic Outlook and IIMF staff calculations.
Notes: The figure plots the real investment rate in machinery and equipment and changes in the price of machinery and equipment relative to the price of consumption. Changes in relative prices are relative to their levels in 1970.
Drivers of relative prices
Guided by previous research on the sources of differences in the relative price of capital goods across countries, we asked whether large declines in relative prices are reflecting faster productivity growth in the capital goods-producing sector, or whether the removal of potential policy distortions, such as reductions in trade costs, drives relative prices.
Disentangling the role of trade barriers is complicated by the fact that trade integration can affect prices through many channels. Lowering import tariffs may induce domestic producers to cut prices to match those offered by foreign competitors. But trade liberalisation also has an indirect effect on prices through its effect on firm productivity (e.g. Pavcnik 2002, Amiti and Konings 2007, Topalova and Khandelwal 2011, Bustos 2011, Ahn et al. 2019).
To disentangle these effects, we follow a three-step approach:
1. Using sectoral producer price data across 40 advanced and emerging market economies and 33 sectors between 1995 and 2011 from the World Input-Output Database, we estimate the elasticity of producer prices to changes in sectoral labour productivity and exposure to international trade. We use import penetration – the ratio of imports to domestic value added – at the sectoral level, instrumented with sectoral import tariffs to isolate changes in trade exposure triggered by policy choice.
2. We estimate the elasticity of labour productivity at the sectoral level with respect to changes in policy-induced import penetration.1
3. We use these estimated elasticities to decompose the overall decline in the relative prices of capital goods into:
- change due to trade integration
- change due to the indirect effect of trade via productivity
- change due to improvements in relative productivity unrelated to trade, and
- change due to all other factors.
The results (Figure 3) suggest that more than half of the decline in the relative prices of machinery and equipment between 2000 and 2011 can be traced to deepening trade integration, both through its direct effect on producer prices and its effect via improvements in labour productivity.
Figure 3 Contributions to changes in relative producer prices of capital goods: 2000-2011 (%)
Source: IMF staff calculations.
Notes: The figure combines the estimated elasticities of producer prices to trade integration and relative labour productivity, and changes in these factors for the capital goods sector between 2000 and 2011 to compute their contribution to the observed change in the producer price of capital goods relative to the price of consumption.
Despite the effects of trade integration and technological progress on the decline in the relative investment prices across income groups, Figure 1 clearly shows that advanced economies experienced larger declines in the relative price of machinery and equipment than emerging market and developing economies. Therefore, it may not be surprising that, in the cross section of countries shown in Figure 4 (top panel), low-income countries continue to face higher relative prices of capital goods, according to the latest available 2011 International Comparison Project data. <