On economic growth and capital flows

Abstract

Trade and output in small open economies are more volatile than in larger economies. The study focuses on how country risk shocks and capital flow volatility affect growth of a small open economy under free trade and imperfect capital mobility. Main effects are in physical capital, in households' consumption and trade and output. In contrast with traditional dynamic models, the economy faces idiosyncratic country risk shocks. I present an open Solow model and a Ramsey-Cass-Koopmans growth model for a small open economy with country risk shocks to households' domestic mobile capital and foreign asset portfolio, using an application of the Modigliani's life-cycle hypothesis on household's savings-stock decisions. This study attempts to show the behavior of households saving under stable and volatile environment. Solow's rule on the saving rate, the Friedman's theory of permanent income and Modigliani's hypothesis help to explain households' behavior on saving. To model capital flows, models include a foreign risk-free asset that households have free access to trade internationally. Models show incomplete market for assets as there a single asset available for households' trade. Then, models are calibrated to quantify the short-run fluctuations from shocks and the long run. Models replicate the empirical regularities well for periods of little capital flow volatility. In periods with greater volatility of capital flows, the Solow model fits data well, and the Ramsey-Cass-Koopmans model well fits physical capital stock and trade. However, the Ramsey-Cass-Koopmans model does not fit consumption and output as actual households do not, or cannot, smooth consumption in periods of greater volatility. I find that country risk shocks constrain investment in physical capital and consumption; output growth co-moves with capital flow changes after 1970s when GDP is pro-cyclical with capital flows. In this environment, trade reversals are associated with sudden stops of capital flows. This study aims to attempt a strong link between empirical and theoretical work, which show robust evidence of the empirical regularities associated to capital flow volatility.Calibrated models simulate impulse responses to transient country risk shocks to an economy that runs a trade-balance deficit or surplus. They lessen physical capital and output in the short and the long terms while improving exports and trade. Further, capital flow scenarios are compared with a counter example where capital mobility is not allowed, and there is free trade. Main results include advantages and disadvantages of economies that either run a trade-balance surplus or a deficit when facing country risk shocks. Finally, the study suggests enforcing public policies to incentive larger saving rates to lessen country risk shocks impacts.