Working Paper: CEPR ID: DP9489
Authors: Gianluca Benigno; Luca Fornaro
Abstract: This paper presents a model of financial resource curse, i.e. episodes of abundant access to foreign capital coupled with weak productivity growth. We study a two-sector, tradable and non-tradable, small open economy. The tradable sector is the engine of growth, and productivity growth is increasing in the amount of labor employed by firms in the tradable sector. A period of large capital inflows, triggered by a fall in the interest rate, is associated with a consumption boom. While the increase in tradable consumption is financed through foreign borrowing, the increase in non-tradable consumption requires a shift of productive resources toward the non-tradable sector at the expenses of the tradable sector. The result is stagnant productivity growth. We show that capital controls can be welfare-enhancing and can be used as a second best policy tool to mitigate the misallocation of resources during an episode of financial resource curse.
Keywords: capital controls; capital flows; endogenous growth; financial resource curse
JEL Codes: F32; F34; F36; F41; F43
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| large capital inflows (F32) | consumption boom (E21) |
| consumption boom (E21) | reallocation of resources from tradable sector to nontradable sector (F16) |
| reallocation of resources from tradable sector to nontradable sector (F16) | stagnant productivity growth in tradable sector (O49) |
| capital inflows (F21) | exacerbate externality from nonexcludability of knowledge in tradable sector (O36) |
| exacerbation of externality from nonexcludability of knowledge in tradable sector (O36) | negative impact on welfare (I30) |
| drop in interest rates (E43) | negative welfare outcomes (I30) |
| capital controls (F38) | preserve productivity growth potential in tradable sector (O49) |