Why Real Interest Rates, Cost of Capital and Price/Earnings Ratios Vary Across Countries

This paper examines how productivity changes a®ect real rates of return and price/earnings ratios in a small open economy. The model provides conditions under which increased productivity in a country's traded goods sector causes prices of non-traded goods to increase relative to the price of traded goods. Under these conditions, real rates of interest decline and the production of certain non-traded durable goods (such as capital equipment and housing) immediately increase. This `overconstruction' has two e®ects. First, the increase in capital relative to labor in these sectors increases the marginal product of labor and hence immediately causes an increase in wages and the prices of non-traded goods. Second, an `oversupply' of capital goods and housing depresses their rental rates in the current period thereby increasing their price to rental ratios or equivalently, their price/earnings ratios.