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External Constraints and Endogenous Growth: Why Didn’t Some Countries Benefit from Capital Flows?

Empirical evidence on the growth benefits of capital inflows is mixed. The growth benefits accruing from capital inflows also appear to be larger for high savings countries. We explain this phenomenon using an OLG model of endogenous growth in open economies with borrowing constraints that can generate both positive and negative growth effects of capital inflows. The amount an economy can borrow is restricted by an endogenous enforcement constraint. In our setting, with physical capital and a pay-as-you-go pensions system, the steady state is unique. However, it can either be constrained or unconstrained. In a constrained economy, opening up to equity and FDI inflows can be bad for growth because it makes the domestic interest rate too low, which endogenously tightens borrowing constraints. Agents decrease savings and investment in productivity-enhancing activities resulting in lower growth. Results are reversed in an unconstrained economy. We also provide a quantitative analysis of these constraints and some policy implications.

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Paper provided by Aix-Marseille School of Economics, Marseille, France in its series AMSE Working Papers with number 1329.

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Length: 35 pages
Date of creation: Mar 2013
Date of revision: Mar 2013
Handle: RePEc:aim:wpaimx:1329
Contact details of provider: Web page: http://www.amse-aixmarseille.fr/en

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  14. Cristina Arellano & Enrique G. Mendoza, 2002. "Credit Frictions and "Sudden Stop" in Small Open Economies: An Equilibrium Business Cycle Framework for Emerging Markets Crises," IDB Publications (Working Papers) 6499, Inter-American Development Bank.
  15. Peter Blair Henry, 2006. "Capital account liberalization: theory, evidence, and speculation," Working Paper Series 2007-32, Federal Reserve Bank of San Francisco.
  16. David Croix & Philippe Michel, 2007. "Education and growth with endogenous debt constraints," Economic Theory, Springer, vol. 33(3), pages 509-530, December.
  17. Aizenman, Joshua & Sushko, Vladyslav, 2011. "Capital Flow Types, External Financing Needs, and Industrial Growth: 99 countries, 1991-2007," Santa Cruz Department of Economics, Working Paper Series qt3fb716f8, Department of Economics, UC Santa Cruz.
  18. Damiano Sandri, 2010. "Growth and Capital Flows with Risky Entrepreneurship," IMF Working Papers 10/37, International Monetary Fund.
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  20. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
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