Working Paper: CEPR ID: DP12808
Authors: Tommaso Monacelli; Luca Sala; Daniele Siena
Abstract: In emerging market economies (EMEs), capital inflows are associated to productivity booms. However, the experience of advanced small open economies (AEs), like the ones of the Euro Area periphery, points to the opposite, i.e., capital inflows lead to lower productivity, possibly due to capital misallocation. We measure capital flow shocks as (exogenous) variations in (world) real interest rates. We show that, in the data, the misallocation narrative fits the evidence only for AEs: lower real interest rates lead to lower productivity in AEs, whereas the opposite holds for EMEs. We build a business cycle model with firms' heterogeneity, financial imperfections and endogenous productivity. The model combines a misallocation effect, stemming from capital inflows, with an original sin effect, whereby capital inflows, via a real exchange rate appreciation, affect the borrowing ability of the incumbent, marginally more productive firms. The estimation of the model reveals that a low trade elasticity combined with high (low) firms' productivity dispersion in EMEs (AEs) are crucial ingredients to account for the different effects of capital inflows across groups of countries. The relative balance of the misallocation and the original sin effect is able to simultaneously rationalize the evidence in both EMEs and AEs.
Keywords: real interest rates; productivity; small open economies
JEL Codes: F32; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Lower real interest rates (E43) | Lower productivity in AEs (O49) |
| Positive innovation to the real interest rate (E43) | Rise in productivity in AEs (O49) |
| Lower real interest rates (E43) | Higher productivity in EMEs (O49) |
| Exogenous rise in the real interest rate (E43) | Rise in productivity in AEs (O49) |
| Exogenous rise in the real interest rate (E43) | Fall in productivity in EMEs (O49) |