**Policy, Research, and External Affairs**

# **International Economic Analysis and Prospects**

# WPS 452

This paper - a product ol' the Inteniational Economic Analysis ane Prospects Division, Intemational Economics Department --- is part of' a larger el'i'ort in PRE to undenstand the detenminants of private investment in developing countries. Copies are available f'ree fronm lhe World Bank, 1818 If Street NW, WashingtonDC2(0433. Pleasecontact Joseph Israel, roomii S7-2 18, exension 31285 (66pagcswithfigures and tablcs).

Investment functions are notoriously difficult to estimate, particularly in developing countries. Shafik presents a model of the determinants of private investment that takes into accouilt common characteristic.s of a developing economy.

Firms' decisions about investment are outcomes of the oligopolistic structure of' markets, putty-clay technology, the inelastic supply of nontraded capital goods, and financial repression. These factors resulh in an importait role l'or markups, interTal finanicing, demand, andl tYie cost of investment goods -- defined, not as the interest rate, but as the price outcomiie f'romii the interaction of supply and dernand in thie market fbor capital goods.

Bly conistructinig an index of thc rclative piice of' investmrn,t goods, it is possible to pros i(le a more meaningful indicator of' the true cost of' capital to the firm under a repressed finiancial svstem. In an econonmy with a well-functionlint credit market, the Keyncsian equilibrium condiition equating the marginal efficiency ol'inxcstment with the interest is likely to hoid. But under financial repression or ihere credit markets are impcrfcct, ltlC interest rate is not a true reflectioni of the cost of capital to tie firm. Instead, a Lombinlatioln of' the price of investenict goods anti **the** quantity **ol'** capital available to the private sector appears to be a more realistic proxy.

Shalik tests thk, model economctrically for Egypt, using the re:ent literature on cointegration and error correction to avoid spurious regression.; and to estimate the long-run equilibrium relationship between investment and its determinants.

She discisses thv limit of'testing econometricldly whe her thc govemment "cro\wids in" or "cro"ws out" private investment anid lIC imnposxsibilitv of conistructing the countcrfactual. It is not possible to conclude xsihthercro%k ding out or in occurred at the nmacrocconomlic level ( to accept the alternative h\ potthesis) bu. it is po.;sibIe to draw conclu,ions a1bout \N hat did nlot happen (the null hypothesis).

'I'Tle model also provides a framework for nalyzing tie cffects of,zovernment policy by considering explicitly thlc role of a number of possible instrumalnts suchi as the exchange rate, **tItIe** quantity of credit ava lable to the private sector, and the composition and financing of' the governiminlt budget. Future research may choose to test otiher cmpiricail pro ies, such as protectioiI, w,%ilitin Ihie same fram \work.

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