DP9489 The Financial Resource Curse

Author(s): Gianluca Benigno, Luca Fornaro
Publication Date: May 2013
Keyword(s): capital controls, capital flows, endogenous growth, the financial resource curse
JEL(s): F32, F34, F36, F41, F43
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9489

This paper presents a model of financial resource curse, i.e. episodes of abundant access to foreign capital coupled with weak productivity growth. We study a two-sector, tradable and non-tradable, small open economy. The tradable sector is the engine of growth, and productivity growth is increasing in 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.