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University of California at Berkeley and International Monetary Fund, respectively. The authors wish to thank Charles Engel, Itay Goldstein, Chad Jones, Enrique Mendoza as well as seminar participants at the University of California at Berkeley, Cornell University, the Federal Reserve Board, Harvard University, the Massachussetts Institute of Technology, the IMF, New York University, the University of Virginia, Yale University, the 2002 meeting of the Society of Economic Dynamics, the 2002 NBER Summer Institute for their comments.
See Eichengreen and Mussa (1998, p. 12): “The classic case for international capital mobility is well-known but worth restating. Flows from capital-abundant to capital-scarce countries raise welfare in the sending and receiving countries alike on the assumption that the marginal product of capital is higher in the latter than in the former. Free capital movements thus permit a more efficient global allocation of savings and direct resources toward their most productive uses.” According to Fischer (1998, p. 2): “Put abstractly, free capital movements facilitate an efficient global allocation of savings and help channel resources to their most productive uses, thus increasing economic growth and welfare.”
Some papers have estimated the same type of benefit as we do here, but with a focus on developed economies. For example, Mendoza and Tesar (1998) find that the welfare benefit of integration is relatively small for the United States—less than 0.5 percent of permanent consumption.
There is a superficial analogy between our results and some conclusions of the literature on trade liberalization. In calibrated neoclassical models the gains from trade liberalization typically amount to less than 1 percent of GDP (de Melo and Tarr, 1992). This has led some authors to conclude that if free trade yields large welfare gains, it must be because of its indirect impact on productivity (Rutherford and Tarr, 2002).
This could occur, for example, because of technological spillovers associated with foreign direct investment (FDI) or an improvement in the allocation of domestic saving induced by financial liberalization. These and other channels are discussed in more detail in the concluding section.
We assume further that βng*(1−γ) < 1 so that the utility is well defined.
We are interested in measuring the benefits of international financial integration that stem from capital scarcity, not from intrinsic and permanent differences in the natural rate of interest between countries.
Countries with low initial capital also have low capital-output ratio since
See next section for more details on how we construct capital stocks.
Next section will propose more refined estimates. Here, we simply want to offer a reasonable order of magnitude.
Assuming a family with infinitely lived agents yields a welfare criterion that averages the short-term and the long-term impact of financial integration. The welfare analysis would be more ambiguous with overlapping generations—as the early and late generations would be affected in different ways by integration.
Population growth is assumed away for simplicity.
This seems consistent with some estimates of the return to investment in developing countries. For example, Isham and Kaufman (1999) find that the average economic rate of return on private projects financed by the World Bank is 14 percent.
The speed of convergence defined locally around the steady state is equal to (δk + ng* − 1) (1 − α), or 5.56 percent with the parameters in Table 1. This measure is not appropriate, however, since we want to consider potentially large deviations from steady state. The figure of 11.49 percent reported in the text is computed numerically from the nonlinear model, assuming an initial capital-output ratio of 1.61 corresponding to a capital gap k/k* of 50 percent.
This puts some discipline on which elasticity of intertemporal substitution one should choose. For instance, with γ = 10, we find an implausible natural interest rate of 17.36 percent.
Easterly, Kremer, Pritchett, and Summers (1993) report that accumulation rates for physical and human capital are very persistent across decades.
Integration makes only one difference in the long run: domestic consumption is lower under integration than under autarky because of the flow of interest payments to the rest of the world. See Appendix I.
The parameters are set to the U.S. economy: τ = 0.66%; θ = 1.28; n = 0.73%; δe = 2.76%. These values imply
The corresponding initial ratios are respectively: k0/k* = 0.70 for the model with physical capital only, k0/k* = Eo/E* = 0.90 for the model without distortions, and k0/k* = E0/E* = 0.82 for the model with distortions.
Mankiw et al. (1992) and Chari et al. (1997) argue that cross-country inequality is due to differences in the rates at which human and physical capital are accumulated. Chari et al present an intertemporal dynamic optimization model in which the accumulation of physical and human capital is affected by a distortion.
The selection is based on OECD membership at the beginning of the time period, so our sample includes three current OECD members, Mexico, Korea, and Turkey. The 65 countries are Algeria, Argentina, Bangladesh, Barbados, Benin, Bolivia, Botswana, Brazil, Cameroon, Central African Republic, Chile, China, Colombia, Republic of Congo, Costa Rica, Cyprus, Dominican Republic, Ecuador, Egypt, El Salvador, Fiji, Ghana, Guatemala, Guyana, Honduras, Hong Kong SAR, India, Indonesia, Islamic Republic of Iran, Israel, Jamaica, Korea, Lesotho, Malawi, Malaysia, Mali, Mauritius, Mexico, Mozambique, Nepal, Nicaragua, Niger, Pakistan, Panama, Papua New Guinea, Paraguay, Peru, Philippines, Rwanda, Senegal, Sierra Leone, Singapore, South Africa, Sri Lanka, Syria, Thailand, Togo, Trinidad and Tobago, Tunisia, Turkey, Uganda, Uruguay, Venezuela, Zambia, and Zimbabwe.
The assumption that
Hsieh and Klenow (2003) and Cohen and Soto (2002) argue that one should construct capital stocks using nominal investment rates instead of PPP investment rates, since poorer countries face systematically higher relative prices for investment goods. Higher nominal investment rates yield comparatively larger capital ratios when there are no distortions—since the equilibrium capital stock k* remains unchanged—and similar capital ratios in the presence of distortions—since both k and k* are adjusted upwards. Using nominal investment rates, we estimate an average capital ratio of 0.63 with distortions and 0.49 without distortions. We find that the welfare gains are smaller. (The results are available upon request to the authors.)
The number for high income non-OECD countries is negative. This is so since the model with distortions does not satisfy the criteria of the first welfare theorem. Countries can be made worse off by international financial integration. Specifically, this happens when countries subsidize capital returns (τ < 0). Capital inflows mean that the subsidy goes to foreign investors.
The figure only includes 60 countries. No data on human capital are available as of 1960 for Benin, China, Republic of Congo, Egypt, and Rwanda.
The difference between the estimates in the first column of Table 8 and those in Table 6 is the difference between the welfare gain of the average and the average of the welfare gains. In practice, the difference is not very large.
For example, Hall and Jones (1999) decompose relative output per worker into a relative capital, relative human capital and relative productivity term. Implicitly, their method includes a relative convergence gap term (the ratio of the convergence gap relative to the U. S. convergence gap) that is allocated between the capital-output component and human capital components. Jones (1997) decomposes steady state relative output into its capital and productivity gap components. His focus on steady state output excludes a convergence term.
An OLS regression yields a significant coefficient of −0.08 and an
Of course, a country that increases its productivity also makes itself more attractive to foreign investors. Our claim is that a country benefits much more from the productivity increase itself than from the resulting capital inflows.
See Borensztein et al. (1998) and Carkovic and Levine (2002) for evidence (and opposite conclusions) on the impact of FDI on growth.
For the log case,
nj depends on the enrollment age for cell j. We assume that np = 15, ns = 10 and nh = 5.
It is important to emphasize that this assumption does not imply that countries are estimated to be close to their steady state. As a famous counterexample, consider the Solow model. It assumes a constant saving rate, but imposes no restrictions on the proximity of countries to their steady state.