Non-Traded Goods and Capital Flows to Developing Countries

We analyze the quantitative impact of the non-tradable sector and structural change on international capital flows. We argue that the allocation puzzle (Gourinchas and Jeanne (2013)) reflects the difference in the magnitudes rather than the direction of net capital flows predicted by the one sector model and those observed in the data. We show that the introduction of a non-tradable sector can reconcile much of the differences between the predictions of the model and the empirical observations, and account for as much as 54% of the allocation puzzle. Complementarity in consumption between tradable and non-tradable goods, as well as structural change, as measured by the movement of labor from agriculture and manufactures (tradable) to services (non-tradable), play a central role in accounting for the relatively low magnitudes of capital flows observed in the data.