Date Added: Nov 2010
This paper investigates the interaction between capital flows and economic development in a dual-economy growth model. In the presence of a market failure in the allocation of resources between a traditional non-traded sector and a modern capital-intensive sector, a government can enhance welfare by a second-best policy that encourages investment and discourages consumption. If installing new capital is costly, then at low levels of development, inducing savings can take precedent over encouraging investment, leading to an inverted U-shaped schedule for government savings as a by-product of the policy. During the accumulation stage of development, labor is attracted to the modern sector, the real-exchange rate depreciates and growth is faster, in comparison to the laissez-faire equilibrium with free capital flows.