Date Added: Aug 2009
In this paper, the authors provide a quantitative framework incorporating heterogeneous producers and underdeveloped domestic financial markets to study the joint dynamics of Total Factor Productivity (TFP) and capital flows. When an unexpected once-and-for-all reform eliminates non-financial distortions and liberalizes capital flows, the TFP of the model economy rises gradually and capital flows out of it. The rise in TFP reflects efficient reallocation of capital and talent, a process drawn out by frictions in domestic financial markets. The concurrent capital outflows are driven by the positive response of domestic saving to higher returns and by the sluggish response of domestic investment to the higher TFP - the latter being another ramification of domestic financial frictions.