International Capital Flows and Structural Change in a Developing Open Economy

Abstract

This paper studies, how allowing foreign capital flows in a developing economy will impact the inter-sector dynamics in terms of allocation of factors of production, relative output and real exchange rate. This paper introduces foreign capital flows to the theory of structural change and unbalanced economic growth (which is predominantly a closed economy framework). The theory of structural change and unbalanced economic growth takes a contrarian view to the standard growth theoretical models based on “Kaldor Facts”. This theory states that as an economy grows and accumulates capital, the sector that has more income elastic consumption and greater capital intensity grows faster than the sector which has a lower income elastic consumption and lower capital intensity. This asymmetric growth leads to unbalanced economic growth and change in relative price among the sectors. Such divergence in sector-wise growth rates is in contrary to the traditional growth theory (which is based on “Kaldor Facts”). This paper has proposed a developing open economy model having two sectors namely traded sector and non-traded sector. The traded sector has higher income elastic consumption along with higher capital intensity & productivity growth as compared to the non-traded sector. The economy has demand side imbalances in form of non-homothetic preferences. The supply side imbalances is in the form of different capital intensity along with different growth rate of productivity across sectors. We have derived the path of aggregate capital stock per unit of labor, sector-wise allocation of factors of production (capital and labor) and relative price path of non-traded to traded sector goods. The results indicate that as an economy grows and accumulates capital, the factors of production start moving out from non-traded sector to traded sector. As a result, the traded sector starts to grow faster than that of non-traded sector. Also the relative price of non-traded sector to the traded sector goods rises (real exchange rate appreciates) with capital accumulation in the economy thereby creating additional pressure on inflation. This inflationary pressure adversely affects competitiveness of domestic firms in international markets and make domestic investment less attractive. Our findings can be linked with the workings of Kalecki (1955) i.e. “The problem of financing economic development” where it states that as an economy grows the subsistence sector shrinks as compared to the income elastic sector. This causes the aggregate price levels to increase. This paper not only extends the theory of structural change and unbalanced economic growth to open economy framework but also introduces non-homothetic preferences to traditional open economy literature which is based on Dependent Economy Framework which predominantly assumes homothetic preferences.