Capital Misallocation and Economic Development in a Dynamic Open Economy

Some countries such as Canada, Italy, and Mexico have experienced a higher growth rate of capital per worker but a lower growth rate for GDP per worker when compared to the United States. This paper tries to reconcile this apparent contradiction in a dynamic open economy model. In the model, capital accumulation and exogenous technology adoption jointly generate output growth. In this environment, sectors with higher import participation have, ceteris paribus, a lower markup over production costs that in equilibrium implies a higher production level. Furthermore, when either sectoral import participation or sectoral productivity changes, capital allocation across sectors is affected, altering the actual rate of return on capital and triggering capital accumulation at a rate that differs from the long-run rate of technology adoption. We calibrate the model for the Mexican economy for 1995-2011. The results show that sectors with a reduction in TFP (total factor productivity) increased capital participation in the aggregate capital formation from 93.5% to 95.7% in the period. Furthermore, if the sectoral productivities had remained constant at the initial level in a counterfactual exercise, the aggregate output would be higher than its initial level, with capital accumulation increasing 74% and driving the rise in GDP.