The Financial Resource Curse

Authors


  • *We thank Fadi Hassan, the guest editors for this special issue, and three anonymous referees for useful comments. We also thank Nathan Converse for help with the data. We acknowledge financial support from the ESRC Grant on the Macroeconomics of Capital Account Liberalization. L. Fornaro acknowledges financial support from the French Ministère de l'Enseignement Supérieur et de la Recherche, the ESRC, the Royal Economic Society, and the Paul Woolley Centre.

Abstract

In this paper, we present a model of the financial resource curse (i.e., episodes of abundant access to foreign capital coupled with weak productivity growth). We study a two-sector (i.e., tradable and non-tradable) small open economy. The tradable sector is the engine of growth, and productivity growth is increasing with the amount of labor employed by firms in the tradable sector. A period of large capital inflows, triggered by a fall in the interest rate, is associated with a consumption boom. While the increase in tradable consumption is financed through foreign borrowing, the increase in non-tradable consumption requires a shift of productive resources toward the non-tradable sector at the expenses of the tradable sector. The result is stagnant productivity growth. We show that capital controls can be welfare-enhancing and can be used as a second-best policy tool to mitigate the misallocation of resources during an episode of financial resource curse.

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