Growth, Tfp, Capital Flows

Growth, TFP, Domestic and International Capital Flows



When an unexpected reform illuminates idiosyncratic distortions and creates liberalization of capital accounts, the TFP of an economy grows steadily, and eventually capital starts flowing out of it. An increase in TFP reflects efficient reallocation of talent and capital, a steady process caused by internal financial market frictions. At the same time, capital outflows are caused by a positive response of local savings to higher returns and by a slower response of local investments to higher TFP. To show the interaction between domestic and international financial markets, a comprehensive reform is to be considered to reduce domestic financial fluctuations. When this is done, the economy experiences growth in TFP and consequently capital inflows. This essay provides a framework that underdeveloped domestic financial markets and heterogeneous production units have joint effects on capital inflows and TPF (total factors of production).

Capital Flows and Productivity Growth

Economic theory suggests that capital often flows from the rich nations to the poor ones, unless the latter have a higher relative cost of investments or lower productivity levels. Another standard theory argues that capital should move into a nation experiencing an increase in sustainable total-factor productivity. There is evidence of developing counties that contradicts this theory, since surprisingly capital tends to move out of nations with fast-growing productivity into economies that perform poorly (Sandri, 2009). The data on the capital flow and TFP confirm that TFP growth follows economic liberation and comprehensive economic reforms. Increased capital flows concur with such processes. Countries like Chile, Taiwan, Brazil and Israel exhibited an increased net capital inflow immediately after they had had complete overhaul of their economic sector, which led to TFP growth. The latter is defined contributions by the labor sector from net earnings per capita.

In the 1980s, there was the first wave of capital account liberalization in emerging economies that saw innovations in the world financial markets. Such innovations made it harder to keep track of capital flows across borders creating measurement problems. Many emerging economies, especially from eastern Asia, adopted explicit policies to measure and improve their net asset positions, particularly amid Russian and East Asian financial crisis of the 1990s. In all these countries, a large-scale economic reform resulted in a period of productivity growth, and at the same time, the countries exhibited an increased capital outflow.

TFP Dynamics and Capital Flows

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During that period in countries, individual citizens choose either to operate using a specific technology, become businessmen or to work for salaries and wages. This worker-entrepreneurship occupation choice by citizens allows entry and exit from the sector of production, which is important resource allocation channels. It created an imperfection in the financial market based on a collateral deficiency in capital borrowing that is proportional to each citizens financial wealth. It is necessary to consider both a closed economy to capital flows and a small open economy, constantly influenced by the world interest rate. However, an idiosyncratic distortion, such as subsides and taxes, will not be considered.

Individuals are influenced by domestic and international capital flows directly or indirectly. They are heterogeneous and live within their means, creativity and their entrepreneurial ability. In particular, an individual can either gain or loss his/her entrepreneurial ability and has to engage in a new entrepreneurial activity (Mushkin, 2003). Furthermore, this new interest is independent from the previous one. The individual also has his or her preference over a consumption sequence and can choose to work for a wage or be involved in an individual operated activity influenced by interest rates. If it is assumed that capital is the only in this country, and the economy is open to flows then its interest rates will be equal to the world indexes.

Financial Frictions and Return on Savings

Lower ? means more financial frictions, when ? =1 corresponds to zero external financing, and ? = +? to ideal credit markets. In this analysis, the market is not an open one and there is the absence of output distortion (?yi ? 0). There is a correlation between ? ratios of equilibrium of external finances and gross domestic products. The lower ?, the lower the external finances to GDP ratio. The interest rate and equilibrium output are compared against GDP ratio to external finances. The left panel will show the effect of the collateral on output. If financial intermediaries are reduced, the output can drop as low as by twenty-seven percent . However, this exercise indicates that financial frictions alone are not enough to explain the difference between less and more developed economies. When a reform is introduced one at a time, idiosyncratic distortions and TFP exponentially increase and slow down smoothly over time. However, if no reforms are implemented in regard with idiosyncratic distortions, TFP remains constant. When distortion is removed, GDP increases to mirror an increase in TFP and the accumulation of per capita later on (Aoki, Benigno, & Kiyotaki, 2007).


When a reform that liberalizes capital flows and illuminates idiosyncratic distortions is introduced, TFP will gradually rise accompanied by an increase in capital outflow. The rise of TFP is a result of the efficient reallocation of talent and capital, but this process is sometimes slowed down by frictions in domestic markets. An increase in domestic savings as a result of a higher return and a slow response of the local investment to high productivity drives capital outflows. It is advisable to understand the domestic financial market if one wants to evaluate the effects of capital account liberalization.

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