The Dynamics of Reforms: Productivity Growth and Capital Flows

Authors

Francisco J. Buera, University of California at Los Angeles
Yongseok Shin, Washington University in St. Louis Department of Economics

Abstract

Why does capital flow out of fast-growing countries? In this paper, we provide a quantitative framework incorporating heterogeneous production units and underdeveloped domestic financial markets to study the joint dynamics of total factor productivity (TFP) and capital flows. When an unexpected once-and-for-all reform eliminates idiosyncratic distortions and liberalizes capital accounts, the TFP of our model economy rises gradually and capital flows out of it. The rise in TFP reflects efficient reallocation of capital and talent, a gradual process drawn out by domestic financial market frictions. The concurrent capital outflows are driven by the positive response of domestic saving to higher returns and by the sluggish response of domestic investment to higher TFP—the latter being another ramification of domestic financial frictions. To highlight the interaction between international and domestic financial markets, we then consider a comprehensive reform that also reduces domestic financial frictions. In this exercise, the economy experiences TFP growth and capital inflows, consistent with the experiences of the few countries that implemented such comprehensive reforms.