WPS5250
Policy Research Working Paper 5250
Undervaluation through Foreign Reserve
Accumulation
Static Losses, Dynamic Gains
Anton Korinek
Luis Serven
The World Bank
Development Research Group
Macroeconomics and Growth Team
March 2010
Policy Research Working Paper 5250
Abstract
This paper shows that real exchange rate undervaluation to foreigners that can only be used to buy up domestic
through the accumulation of foreign reserves may tradable goods. This raises the relative price of tradable
improve welfare in economies with learningbyinvesting versus nontradable goods (i.e. undervalues the real
externalities that arise disproportionately from the exchange rate) at the static cost of temporarily reducing
tradable sector. In the presence of targeting problems tradable absorption in the domestic economy. However,
or when policy choices are restricted by multilateral since the tradable sector generates greater learningby
agreements, firstbest policies such as subsidies to capital investing externalities, it leads to dynamic gains in the
accumulation, or subsidies to tradable production are form of higher growth. The net welfare effects of reserve
not feasible. A neomercantilist policy of foreign reserve accumulation depend on the balance between the static
accumulation "outsources" the targeting problem or losses from lower tradable absorption versus the dynamic
overcomes the multilateral restrictions by providing loans gains from higher growth.
This papera product of the Macroeconomics and Growth Team, Development Research Groupis part of a larger effort
in the department to understand the determinants of economic growth. Policy Research Working Papers are also posted
on the Web at http://econ.worldbank.org. The author may be contacted at lserven@worldbank.org.
The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development
issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the
names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those
of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and
its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent.
Produced by the Research Support Team
Undervaluation through Foreign Reserve Accumulation:
Static Losses, Dynamic Gains
Anton Korinek e
Luis Serv´n
University of Maryland World Bank
JEL Codes: F31, F41, F43
Keywords: foreign reserve accumulation, real exchange rate
undervaluation, neomercantilism
The authors would like to thank Ibrahim A. Elbadawi, Zheng Michael Song, Joseph E. Stiglitz
and ShangJin Wei as well as participants at a World Bank seminar and at an HKIMR conference for
helpful comments and discussions. Korinek is grateful for the World Bank's hospitality and financial
support for this research project. The views expressed in this paper are ours and do not necessarily
reflect those of the World Bank, its Executive Directors, or the countries they represent.
1
1 Introduction
Over the past decades, a number of emerging economies, notably in Asia, have expe
rienced fierce economic growth, while also accumulating large amounts of foreign re
serves.1 These observations contrast with standard neoclassical open economy growth
models in which economies with rapid productivity growth are predicted to run cur
rent account deficits so as to import capital and accelerate the buildup of the domestic
capital stock (see e.g. Gourinchas and Jeanne, 2007, for a critical analysis).
The literature has proposed two main categories of explanations for these facts:
First, reserve accumulation might be a form of precautionary savings to insure against
future countryspecific adverse shocks.2 However, it has been difficult to reconcile the
massive amounts of reserves observed in the data with realistic magnitudes of shocks
that a country might want to insure against.3
According to a second category of explanations, much of the recent reserve ac
cumulation in Asia results from a form of "neomercantilist" policy to increase net
exports so as to enhance economic growth, as argued for instance by Dooley et al.
(2003) or Rodrik (2008).4 These papers argue that developing countries might enjoy
learningbydoing externalities in the spirit of Arrow (1962) and Romer (1986). A
policy of fostering exports by undervaluing the real exchange rate through foreign re
serve accumulation would increase domestic production and lead to dynamic welfare
gains due to these externalities.
The subject of our paper is to develop a formal dynamic model of the welfare
effects of real exchange rate undervaluation and to assess the desirability of reserve
accumulation and real exchange rate undervaluation as a secondbest instrument to
internalize such learningbydoing externalities.5
Our setup is based on the notion that reserve accumulation and undervaluation
solve a targeting problem: In a firstbest world with a full set of instruments, govern
ment would like to subsidize investment to induce agents to internalize their learning
bydoing externalities. However, if policymakers face difficulties in targeting produc
tive investment opportunities, an alternative mechanism is needed. By lending to for
1
China, for example, was sitting atop of USD 2.4 trillion of official foreign reserves by early 2010
 a whopping 49% of its GDP, and experienced growth of more than 9% on average over the past
decade (data from the People's Bank of China). Its performance on both measures was followed
closely by other Asian tiger economies such as Taiwan and South Korea.
2
See e.g. Aizenman and Marion (2003), Durdu et al. (2009), Mendoza et al. (2009) or Carroll
and Jeanne (2009) for proponents of this view.
3
e
This is discussed e.g. in Jeanne and Ranci`re (2009). However, see Carroll and Jeanne (2009)
for a more positive assessment.
4
Mercantilism was a widespread view among economic thinkers in Europe during the period of
1500 1750 and is still a frequent argument in the public discourse among noneconomists.
5
For the purposes of this paper, we equate the term "reserve accumulation" to "real exchange
rate undervaluation," since reserve accumulation in our model of closed capital accounts requires
that more tradable goods are exported, which makes tradable goods in the domestic economy scarcer
and depreciates the real exchange rate.
2
eigners who spend only on tradable goods, government indirectly targets the tradable
sector, which generates large learningbyinvesting externalities and boosts aggregate
saving and investment. In a way, the government "outsources" the targeting problem
to foreigners.
The difficulty of targeting policy measures at specific sectors has long been em
phasized by the economic literature. First, selective subsidies pose potentially severe
agency problem, as they offer ample opportunities for rent extraction.6 Secondly,
sectorspecific targeting imposes vast knowledge requirements on government, which
are unlikely to be met in practice. Pack and Saggi (2006) survey the literature on this
topic and present a detailed list of such requirements.7 Furthermore, WTO rules have
severely curtailed the ability of developing countries to deploy sectorspecific taxes
and subsidies, as any such actions if they lead directly or indirectly to expanding
exports would fall by design under restrictions on "tradedistorting interventions."8
Our formal model describes a small economy with two intermediate goods sectors,
a tradable and a nontradable sector. The two intermediate goods can be combined
to yield a composite final good that can be used for consumption and investment.
Both intermediate sectors employ two factors, labor and capital, where our measure of
capital includes all factors that can be accumulated, i.e. physical as well as intangible
forms, such human capital in the form of schooling or training, organizational capital,
institutional capital etc. This is a common interpretation of capital in the endogenous
growth literature, since the accumulation of all these factors has the potential of
spillover effects. As is common in many developing economies, we assume that capital
accounts are closed for private agents, and only government can trade financial assets
with the outside world.
We make two crucial assumptions in our analysis: First, we assume that the
economy exhibits learningbyinvesting externalities, i.e. that the level of technology
in the economy is proportional to the amount of capital accumulated. This implies
that the economy is of the AKtype as in Romer (1989), i.e. that growth is endogenous
to the economic system and can be affected by policy. For evidence on such spillover
effects in developing countries see e.g. Xu and Sheng (2010). Syverson (2010) provides
a more general survey.
Secondly, we assume that tradable goods are more intensive in our measure of
capital than nontradable goods, which implies that the production of tradable goods
6
Even in economies with highly developed institutions, these concerns are of major importance,
as illustrated e.g. by the large number of fraudulent schemes seeking to profit from the European
Union's Common Agricultural Policy (see e.g. New York Times, Oct. 27, 2009, "Fraud Plagues
Sugar Subsidy System in Europe" or New York Times, Dec. 28, 2009, "Olive Growers' Claims
Prompt Investigation").
7
Klimenko (2004) describes conditions under which even a perfectly benevolent government that
attempts to target specific industries may end up inefficiently steering a country away from its
longrun comparative advantage, if information is imperfect.
8
This point is noted also by Charlton and Stiglitz (2006) and Rodrik (2009). UNCTAD (2006)
describes in detail the restrictions on national policies imposed by multilateral trade agreements.
3
generates greater learningbyinvesting externalities than nontradable goods. Note
that we expect such externalities to be of particular importance for nonphysical forms
of capital, such as human capital. An undervalued real exchange rate raises the price
of tradable goods and in accordance with the StolperSamuelson theorem the
private returns on all forms of capital that are employed relatively more intensely in
the tradable sector, i.e. it moves the private returns closer to the social returns of
such capital that include the learningbyinvesting effects. In response to this price
signal private agents increase their saving and accumulation of such capital, leading
to dynamic welfare gains.
To conduct our welfare analysis, we derive a simple analytical formula for welfare
that directly captures the tradeoff between the static distortions that our policy mea
sures introduce into the economy and the dynamic gains that are reaped from higher
growth. This tradeoff can be elegantly captured in a diagram of static allocative
efficiency versus dynamic growth.
In our framework, reserve accumulation permanently removes tradable goods from
the economy in order to increase the relative price of tradables. This policy creates a
firstorder static welfare loss every period, as real resources that could otherwise have
been consumed leave the economy. On the other hand, the undervalued exchange
rate entails a firstorder dynamic growth benefit.
We show that the net welfare effect of reserve accumulation may be positive under
certain conditions, specifically in economies in which the tradable sector is signifi
cantly more intensive in our measure of capital and which exhibit a high willingness
to substitute consumption intertemporally. We term economies that fulfill these con
ditions tradedependent economies.
We analyze our model economy in a steady state in which reserve accumulation
occurs every period and reserves are never repatriated. (Decumulation of reserves
would lead to the opposite effects of accumulation, i.e. it would reduce growth.) This
is equivalent to throwing tradable goods into the ocean and is of course an extreme
assumption. In practice foreign reserves yield important insurance benefits (see e.g.
e
Jeanne and Ranci`re, 2009), or could be used for imports at a later stage of the
country's development. In such instances, a policy of reserve accumulation would be
welfareenhancing under considerably milder conditions.
We also consider the case of an economy that obtains an exogenous supply of
tradable goods in addition to the regular output from the tradable production sec
tor. Examples include natural resource discoveries, foreign aid, or speculative capital
inflows. We find that such economies exhibit a form of "Dutch disease:" a higher
supply of tradable goods in the economy reduces the domestic returns to capital and
decreases the economy's growth rate. For tradedependent economies, the resulting
decrease in the growth rate is so large that they are worse off as a result of the inflow of
additional tradable goods. Put differently, in countries for which reserve hoarding is
welfareimproving, it is also the case that (untied) foreign aid, or resource discoveries,
are welfarereducing.
4
After establishing our main result, we relax the severity of the targeting prob
lem and investigate optimal government policies: We continue to assume that the
government is unable to subsidize capital formation, but we suppose that it can dif
ferentially intervene in the economy's sectors to distort the economy's real exchange
rate, e.g. by imposing subsidies and taxes on tradable vs. nontradable goods, or by
reallocating government spending from nontradable to tradable goods. In each of
the two cases, the static efficiency losses from the price distortion in a given period
are secondorder, whereas the dynamic welfare gains of the higher growth that results
from real exchange rate undervaluation are firstorder. If government can correctly
target policy measures at individual sectors, it is therefore always optimal to imple
ment them.
Our analysis focuses on the real rather than the nominal exchange rate. In models
with sticky nominal prices or wages, such as e.g. New Keynesian models, an exchange
rate devaluation temporarily reduces the real cost of consumption or production, and
the resulting lower real prices raise the demand for goods or labor, resulting in higher
output. However, as all nominal variables adjust to their equilibrium values, the effect
fades out. Our paper, by contrast, focuses on real exchange rate undervaluation and
offers a structural explanation for how such a policy can provide a persistent boost
to growth.
The effects of an undervalued currency resemble in many ways those of restric
tive trade policy (for a detailed discussion see e.g. Mussa, 1985). An undervalued
currency simultaneously encourages the domestic production of tradables, similar to
a production or export subsidy, and discourages the domestic consumption of trad
ables, similar to a consumption tax or import tariff. Both effects increase the current
account. However, unlike restrictive trade policy, an undervalued currency does not
discriminate between locally and foreignproduced tradable goods.
Literature
Our work is related to the literature on exportled growth, which has typically focused
on learning and improvements in human capital, higher competition, technological
spillovers, and increasing returns to scale (see e.g. Keesing, 1967). Among the general
equilibrium models that have been developed to illustrate these effects are Romer
(1989), who shows that free trade can enhance growth by increasing the number of
intermediate goods and Grossman and Helpman (1991) and Edwards (1992), who
demonstrate that an increase in technological spillovers through trade can raise the
longrun growth rate of an economy. The mechanism through which these spillovers
take place is more or less assumed exogenously. The model we propose here, by
contrast, focuses on the capital accumulation process: higher savings rates in an
endogenous growth environment in the style of Romer (1986) translate into higher
growth.
Our framework is closely related to the models of interindustry spillovers familiar
5
from the infant industry literature (Succar, 1987; Young, 1991). Such models feature
industries experiencing learning externalities, at rates that may vary across indus
tries. Our paper embeds such a framework into an otherwise standard open econ
omy endogenous growth model. The conditions characterizing our tradedependent
economies can be seen as the analogous of the MillBastable test that determines
whether government intervention in support of infant industries is welfareimproving.9
More recently, Rodrik (2008) has presented empirical evidence and has developed
a model of growth through exchange rate undervaluation similar to ours. Our the
oretical analysis differs in two main aspects: First, Rodrik does not investigate how
undervaluation can help to internalize the learningbyinvesting spillovers. Instead, he
assumes that the returns to capital in developing countries are artificially depressed
because of difficulties in appropriability in the tradable sector, and he proposes that
real exchange rate undervaluation can reduce this distortion. In other words, Ro
drik assumes the tradable sector is special because it suffers more from distortions;
we assume the tradable sector is special because of its learningbyinvesting spillover
effects. Secondly, our paper contributes a welfare analysis of the static losses ver
sus dynamic gains that arise from exchange rate undervaluation in economies with
endogenous growth. We express both in a tractable analytical formula and in an
intuitive graphical diagram.
Aizenman and Lee (2008) investigate the policy implications of learningbydoing
externalities in two/threeperiod models. The focus of their paper is on how different
forms of learningbydoing externalities call for different firstbest policy interventions.
We focus instead on the benchmark Romer (1989) learningbyinvesting externality
and focus on secondbest policy interventions in the presence of a targeting problem.
We also derive quantitative welfare and policy implications.
In the empirical literature, the question whether higher exports can lead to higher
growth has not been conclusively settled. Though several more recent empirical
studies are available, the perhaps most telling summary of this literature is given in a
survey by Giles and Williams (2000), which concludes that "it is difficult to decide for
or against [the exportled growth hypothesis], as the results are conflicting." Evidence
on learningbydoing externalities associated with exporting is likewise inconclusive,
owing in large part to the difficulty in disentangling productivitybased selection
into exporting from true learningbyexporting effects (Harrison and RodriguezClare,
2009).10 Given the inconclusive results in the empirical literature, our paper aims to
theoretically clarify the channels through which undervaluation can increase growth
and welfare so as to better guide future empirical research.
9
The MillBastable test essentially states that the discounted stream of productivity gains gen
erated through learning should exceed the discounted cost of the government intervention required
to achive the learning; see e.g. Melitz (2005) for some specific applications.
10
Rodrik (2009), however, finds that a large (tradable) manufacturing sector leads to positive
growth externalities.
6
2 Model Structure
Our benchmark model describes an economy with a continuum of infinitelylived
representative consumerworkers of mass 1. There are two factors, labor and capital,
that are used to produce two intermediate goods, tradable and nontradable goods
T and N . The two intermediate goods in turn can be combined to yield a final
consumption/investment good, which also serves as a numeraire good and which we
assume cannot be traded across borders.
2.1 Representative consumerworkers
Each representative consumerworker maximizes the present discounted value of his
utility, which consists of a CRRA period utility function with intertemporal elasticity
of substitution 1/, discounted at factor . Consumerworkers inelastically supply
¯
an amount L = 1 of labor at the given market wage w and rent out their capital
stock K at the given gross rental rate R and experience a depreciation rate . They
choose how much of their factor income to consume C and how much of it to invest
I to maintain and augment the capital stock. Note that our measure of capital K
accounts not only for physical capital but also for human capital such as education or
onthejob training, for organizational capital and for all other factors that the agent
can accumulate and that yield learningbyinvesting externalities.
A representative agent's optimization problem, subject to his period budget con
straint, his law of motion of capital, and a transversality condition that rules out
Ponzi schemes is11
C 1
max U = max t (1)
t
1
s.t. C + I = w + RK
Kt+1 = (1  ) K + I
lim (1 + R  )t Kt = 0
t
The Euler equation determines the consumption growth rate DE that private agents
in the economy choose,
Ct 1
= [(1 + Rt  )] =: 1 + DE (2)
Ct1
Consumption growth is an increasing function of the return to capital. Furthermore,
the effect of the interest rate is stronger the higher the agent's willingness to engage
in intertemporal substitution, as expressed by the elasticity 1/.
11
Since capital accounts in the economy are closed, private agents cannot borrow or save abroad.
7
2.2 Intermediate goods sectors
The tradable and nontradable intermediate goods trade at prices pT and pN respec
tively in the domestic economy. We define the real exchange rate q as the relative
price of the two
q = pT /pN (3)
Note that an appreciation of the real exchange rate is reflected as a decrease in q.
The tradable goods sector hires capital KT and labor LT using a CobbDouglas
production function FT with capital share of and laboraugmenting technology AT
and solves the profit maximization problem
max pT KT (AT LT )1  RKT  wLT
KT ,LT
Similarly, the nontradable sector rents capital KN and hires labor LN to produce
the nontradable good N using a CobbDouglas production function with capital
share and laboraugmenting technology AN . Nontradable firms optimize profits
according to the expression
max pN KN (AN LN )1  RKN  wLN
KN ,LN
We make the following assumption:
Assumption 1 The capital share in the tradable sector is greater than in the non
tradable sector, i.e. > .
If the tradable sector employs relatively more capital, then it will also draw more
investment and will generate greater learningbyinvesting externalities, as we discuss
in more detail below.
Note that our assumption on relative capital intensities is especially likely to hold
given that we interpret capital more broadly than what is captured by the notion of
physical capital.
By dividing the firstorder conditions of both sectors with respect to capital, we
obtain the following necessary condition for the capital market to be in equilibrium,
i.e. for capital to earn the same returns in both sectors (see appendix for details),
pT KN (AN LN )1
1
q= = (4)
pN KT (AT LT )1
1
In other words, the real exchange rate has to be more depreciated (i.e. q has to
be higher) the more productive capital is in the nontradable sector compared to the
tradable sector. (If the marginal productivity of capital suddenly increased in the non
tradable sector, a decline in the relative price of nontradables would reequilibrate
capital markets.) Similarly, by combining the firstorder optimality conditions on
8
labor we obtain an equilibrium condition for labor to earn the same returns in both
sectors,
pT (1  ) KN A1 L
N N
q= = (5)
pN (1  ) KT AT L
1
T
According to this expression, the real exchange rate q has to be higher (i.e. more
depreciated) the more productive labor is in the nontradable sector compared to the
tradable sector.
2.3 Technology
In order to endogenize the economy's growth rate, we follow Arrow (1962) and Romer
(1986) in assuming that the economy exhibits aggregate learningbyinvesting spillover
effects. Specifically, suppose that the aggregate level of productivity in the interme
diate goods sectors rises in proportion to the change in the aggregate capital stock
K so that AT AN K. Appropriately normalizing the units of T and N , we
write12
AT = AN = K (6)
2.4 Final goods sector
The final goods sector buys tradable goods T and nontradable goods N at prevailing
market prices and assembles them into final goods Z using a CobbDouglas production
function with a share of tradable goods and 1  of nontradable goods, using
technology AZ ,
Z = FZ (T, N ) = AZ T N 1 (7)
Since good Z is the numeraire, its price is pZ 1. The strategy of firms in the final
goods sector is to maximize profits
max AZ T N 1  pT T  pN N (8)
T,N
Given the CobbDouglas technology, firms use inputs in proportion to their relative
price,
pT N
q= = ˇ (9)
pN 1 T
This optimality condition captures that the real exchange rate reflects the relative
scarcity of tradable and nontradable goods, i.e. it depreciates (q rises or tradable
goods become more expensive) the scarcer tradable goods are relative to nontradable
goods.
12
The assumption that technology in both sectors is equally affected by the learningbydoing
externality is necessary to obtain balanced growth, i.e. to ensure that the relative size of the two
intermediate goods sectors remains constant over time and does not diverge.
9
3 Equilibrium
In this section, we use combine the optimality conditions of firms and consumers of
the previous section to solve first for the economy's decentralized equilibrium, then
for the optimum that would be chosen by a social planner. As a first step, we impose
the economy's market clearing conditions.
3.1 Market clearing
Market clearing in the factor markets implies
KT + KN = K (10)
¯
LT + LN = L = 1 (11)
Similarly, in the nontradable intermediate sector we require
N = FN (KN , LN ) (12)
In the tradable sector, the market clearing condition depends on the country's
current account balance. In our benchmark solution, we assume that the economy's
capital account is closed and therefore the current account is in balance. Later we
will generalize this result. Under a balanced current account, market clearing requires
that the entire supply FT (ˇ) of tradable goods is employed in the production of final
goods,13
T = FT (KT , LT ) (13)
Substituting the production functions from the two market clearing conditions
(12) and (13) into the optimality condition (9) for the final goods sector, we obtain
KN (AN LN )1
q= ˇ (14)
1  KT (AT LT )1
3.2 Equilibrium factor allocations
Throughout most of our analysis, it will prove convenient to capture the equilibrium
allocations in the economy for given technology and factor endowments by two vari
/
ables, the capital ratio = KN /KT and the labor ratio = LN /LT that describe
how factors are allocated across the two intermediate goods sectors. For any factor
13
The given model contains only one tradable good; therefore the only motive for trade is to
transfer resources intertemporally. This implies that we abstract from all trade for reasons of static
comparative advantage or of varieties, and the assumption of closed capital accounts implies that
no international trade takes place between the economy and the rest of the world.
10
ratios and , it is straightforward to use the marketclearing conditions (10) and
(11) to find the sectoral factor allocations
1
KT = K KN = K (15)
1+ 1+
1 ¯ ¯
LT = L LT = L (16)
1+ 1+
To obtain the optimal values for the factor ratios and , we combine the opti
mality conditions for the capital market (4) and the labor market (5) each with the
goods market optimality condition (14) to eliminate q. We obtain optimal capital
and labor ratios of
1
= ˇ (17)
1 1
= ˇ (18)
1
As is typical for CobbDouglas production technologies, the optimal ratio of factor
allocations to the two sectors is determined by the relative shares of the two factors
in final goods production. Following assumption 1, it is easy to see that < , i.e.
the tradable sector is relatively more capitalintensive.
3.3 Consolidated production technology
For any pair (, ) we can substitute the optimal factor allocations from (15) and
(16) as well as the levels of technology AT and AN in the tradable and nontradable
production functions FT (KT , LT ) and FN (KN , LN ) and assemble the two interme
diate goods using the final goods production function. This yields the economy's
consolidated production technology for final goods14
FZ (T, N ) = A (, ) K (19)
where the social marginal return on capital A = A(, ) is a function solely of the
sectoral capital and labor ratios and ,
(1) (1) (1)(1)
1 1
A(, ) = AZ
L1~ , (20)
1+ 1+ 1+ 1+
and where we denote = + (1  ) the weighted average capital share in the
~
economy. This reflects that the economy's aggregate production technology for final
goods is of the AKform.
14
For details see appendix A.2.
11
3.4 Decentralized equilibrium
We denote the social return on capital in the decentralized equilibrium as A =
A ( , ). However, from the perspective of individual agents, the aggregate capital
stock K, and therefore the level of technology, is exogenous. In the decentralized
equilibrium, the private return on capital R equals the marginal product of capital
1
in both intermediate goods sectors so that R = pT KT (AT LT )1 in accordance
with the firstorder conditions on capital for tradables. We substitute the optimality
1
condition on tradable inputs pT = N T
to solve for the private return on capital
R = AZ T N 1 /KT = A
~ (21)
where the last step follows from /KT = (1 + )/K = /K. ~
~
The private marginal return on capital R captures a fraction of the social return
A that is precisely the weighted average capital share in the production of final goods.
By extension, the learningbyinvesting externality is the remainder, (1  )A. It is
~
of equal magnitude to the weighted labor share 1  in final production, since we
~
assumed technology to be laboraugmenting. Note that both the private and the
social return to capital are independent of the level of the capital stock.
Given the private return on capital R, decentralized agents pick a level of in
vestment that implements the optimal growth rate DE from their Euler equation
(2).
3.5 Social planner
A social planner in the described economy maximizes the same objective as the repre
sentative agent in section 2.1, but internalizes the learningbyinvesting externalities.
This implies that he recognizes that
RK + wL = A K
when determining the optimal amount of capital accumulation. The social marginal
return on capital consists not only of the private return R = A but also of higher
~
wage income d(wL)/dK = (1  )A that is achieved from the resultant higher level
~
of technology. This yields the social planner's Euler equation
Ct 1
= [ (1 + A  )] =: 1 + SP (22)
Ct1
Since decentralized agents internalize only a fraction R = A < A of the social
~
return to capital, it is clear that the planner's growth rate SP is greater than the
decentralized growth rate DE of equation (2). In other words, decentralized agents
invest too little and consume too much. This leads to suboptimally slow growth in
the economy and creates a natural case for policy intervention, which we will discuss
further in section 4.
12
3.6 Steady state
Economies with an AK production technology exhibit a steady state in which the
interest rate is constant and the capital stock, output and consumption grow at a
constant rate (Romer, 1986). In the decentralized equilibrium this growth rate is
DE as determined by equation (2); in the social planner's equilibrium it is SP as
given by (22). Furthermore, in both equilibria the social return on capital is A = A .
In this section we describe the steady state in such an economy for a given growth
rate and social return A.
In order to implement a growth rate of , investment must make up for deprecia
tion and augment the capital stock at that rate so that
I = ( + ) K (23)
The remaining output will be consumed every period. Aggregate output is the prod
uct of the capital stock K times the given social return on capital A; therefore we
denote consumption as
C = AK  I = (A   ) K (24)
Given an initial level of capital K0 , we express the capital stock and consumption in
the economy as
Kt = (1 + )t K0 and Ct = (A   ) (1 + )t K0
The evolution of the economy is therefore fully determined by the pair (A, ). We
can express welfare in the economy as a function of these two variables:15
1
C 1 [(A   )(1 + )t K0 ]
U (, A) = t = t =
1 1
1
1 [(A   )K0 ]
= ˇ (25)
1 1  (1 + )1
It is clear that this expression is an increasing function of A, i.e. that welfare is
higher the greater the social return on capital every period. On the other hand, the
dependence of welfare on the steady state growth rate is nonmonotonic: for a given
social return A, welfare is maximized when the growth rate is the one chosen by the
15
For the case of = 1 the period utility function becomes CobbDouglas, and the expression for
welfare is
U (, A) = t log C = t {log [(A   )K0 ] + t log(1 + )} =
log(A   ) + log K0 log(1 + )
= +
1 (1  )2
13
UDE USP SP
SP
DE
DE
A
A
Figure 1: Isoutility curves in (A, )space
social planner (22). For lower growth rates, e.g. for the one chosen by decentralized
agents according to their Euler equation (2), welfare is an increasing function of the
growth rate; once the socially optimal level has been surpassed, welfare is a declining
function of the growth rate.
This nonmonotonic relationship stems from a tradeoff between current consump
tion and future growth: A higher growth rate raises future consumption, which raises
future welfare; this effect is captured by the denominator in (25) and is dominant for
low growth rates < SP . On the other hand, implementing a higher growth rate
requires higher investment, and therefore lower levels of initial consumption, which
reduces welfare; this is reflected in the numerator of expression (25) and dominates for
high growth rates > SP . The social planner chooses the optimal tradeoff between
shortterm consumption and longrun growth.
In figure 1 we present a diagram with the resulting isoutility curves in the (A, )
space. The two upward sloping lines DE (A) and SP (A) depict the growth rates
that decentralized agents and the social planner would pick for different levels of
productivity A in the economy, as determined by their Euler equations (2) and (22).
If we indicate the social return on capital A in the economy by the dotted vertical
line, the decentralized equilibrium DE and the social planner's optimum SP lie at
the intersections of this line with the DE (A) and SP (A) schedules.
We have also drawn isoutility curves through these two equilibria. The level
of utility in the decentralized equilibrium is below that in the social optimum, as
rightward movements in the graph correspond to higher levels of utility. Note that
the isoutility curves are cshaped, and an isoutility curve requires the lowest social
14
product of capital precisely at the point where the curve intersects with the social
planner's SP (A)line. This is because the growth rate chosen by the social planner
is optimal for a given level of A.
4 Firstbest Benchmark
The decentralized equilibrium exhibits an inefficiently low rate of investment since
decentralized agents do not internalize the social returns to capital that stem from
learningbyinvesting externalities. In the absence of targeting problems, firstbest
policy responses would aim to induce decentralized agents to internalize these exter
nalities by eliminating the wedge between the private and social returns to investment.
In our model, this could be achieved through subsidies on capital holdings or on the
returns to capital, an investment tax credit, or subsidies to production.
Suppose government imposes a subsidy sK to capital holdings that is financed by
a lumpsum tax T .16 This raises the private returns to capital and therefore induces
agents to save more. The agent's optimization problem can be modified accordingly
by expressing his budget constraint as
Ct = [1 + R + sK  ] Kt + w  Kt+1  T
This implies the Euler equation
Ct 1
1 + (sK ) = = [(1 + R + sK  )] (26)
Ct1
The subsidy unambiguously raises growth, since the higher returns on capital induce
a substitution effect that increases capital investment, but no income effect because of
the lumpsum tax. Using (23), the steadystate level of consumption can be derived
as
Ct = (R + sK )Kt + w  T  It = RKt + w  It = [A  (sK )  ] Kt
A subsidy on capital in the amount of s = (1  )A raises the returns on capital
K ~
to the social level R + sK = A + (1  ) A = A and therefore implements the
~ ~
socially optimal growth rate, given by equation (22).
In our model, the following policies are equivalent to subsidies on capital accu
mulation itself: A subsidy on the returns to capital in the amount of sR = (1  )/~
~
per dollar of interest income would raise the returns on capital to R(1 + sR ) =
A (1 + 1~ ) = A . An investment tax credit cI = 1  per dollar invested would
~ ~
~
lower the private cost of investment from I to (1  cI )I = I and would eliminate the
~
difference between the private and social returns to capital (SaintPaul, 1992). Simi
larly, a production subsidy at rate sZ = (1  )/~ would raise the private returns on
~
16
Since labor supply is inelastic in our framework, lumpsum taxes can equivalently be viewed
as taxes on either wage income or consumption, both of which would be nondistortionary. To
complement our analysis here, we will analyze distortionary taxation in the following section.
15
capital (and also labor) and would restore the socially optimal savings incentives for
decentralized agents. All of these measures would push the decentralized investment
rate toward the social optimum.
Proposition 1 A subsidy sK on holding capital, an investment tax credit cI , or a
subsidy sZ on production increase the private return on capital and raise growth in
the decentralized equilibrium. The social planner's equilibrium can be implemented by
setting sK = (1  )A or sR = (1  )/~ or cI = 1  or sZ = (1  )/~ .
~ ~ ~ ~
By the same token, taxing capital, interest income, investment, or production
has the opposite effects from what we just described: for example, a capital tax K
corresponds to a negative subsidy sK =  K in the calculation above, a tax R on
the returns to capital corresponds to a negative subsidy sK =  R R per unit of
capital, a tax on investment is equivalent to a negative subsidy of sK = A I , or
a production tax Z is equivalent to a negative subsidy on capital of sK = ~ A Z
plus a lumpsum tax in the amount of  Z (1 )A K. Each of these policy measures
~
reduces the private return on capital and the economy's growth rate:
Corollary 2 A tax K on holding capital, a tax R on the returns to capital, a tax
I on investment, or a tax Z on final goods production reduce the private return on
capital and lower growth in the decentralized equilibrium of the economy.
In figure 1 firstbest policy measures can be described as a vertical movement
along the A line from the decentralized equilibrium DE to the social optimum SP :
government revenue is raised in a nondistortionary manner so that the social pro
ductivity of capital remains constant at A , whereas the growth rate in the economy
increases from DE to SP . Welfare is clearly increased.
Targeting Problem The discussed firstbest policy measures assume that the gov
ernment possesses very precise information, and that its institutional capacity to
overcome agency problems, and prevent corruption and abuse, is similarly very high.
For example, in an environment where some agents have socially wasteful investment
opportunities that do not generate productive output, a general investment subsidy
may be welfarereducing because it provides incentives for such wasteful projects to be
implemented. By the same token, targeting a specific sector may be difficult because
it is hard for government to verify whether a given expenditure is indeed intended
to create capital for the sector in question. These problem are especially severe in
our framework given our broad notion of capital, which includes human capital and
various other forms of intangible capital.
The targeting problem can be overcome if the private sector has superior infor
mation and plays a role in the allocation of subsidies. One such measure is to raise
the domestic price of tradable goods through foreign reserve accumulation: foreign
ers purchase only tradable goods; therefore the policy measure targets precisely that
sector. Furthermore, foreigners only spend their money on useful goods; therefore
16
they filter out wasteful investment expenditures that do not yield any output. In the
following section 5, we describe conditions under which real exchange rate underval
uation through reserve accumulation is indeed welfareimproving.
Public Capital Accumulation Let us discuss one further policy option that is
sometimes proposed as a firstbest measure for internalizing learningbyinvesting
externalities: that government makes up for the inefficiently low private level of in
vestment through public investment in the capital stock. Assume that government
invests I G financed by lumpsum taxation, that it rents out the accumulated capital
stock K G to the intermediate goods producers at the prevailing market interest rate
R, and that it transfers the resulting returns to the representative agent in lump
sum fashion. For a given level of the private capital stock K, this would increase the
aggregate capital stock to K + K G and would seemingly raise the economy's growth
rate to the socially optimal rate SP .
However, if we solve the decentralized agent's optimization problem augmented
by this policy measure (see appendix A.3), it can be seen that the decentralized
agent's Euler equation is unchanged from the one representing the nointervention
decentralized equilibrium (2). In other words, given that he internalizes only a return
to capital of R = A , the decentralized agent does not want to see his consumption
~
grow at a rate faster than DE . Whenever government increases its investment by
I, the private agent would reduce his investment in an equal amount in order to
return to his private optimum. In our framework, government accumulation of capital
therefore fully crowds out private investment.17
These results hold for public investment in capital that aims to act as a substitute
for private investment. On the other hand, if government invests in forms of capital
that are complementary to private capital accumulation, such as upgrading a coun
try's infrastructure or improving the institutional environment, then it increases the
incentives for private agents to invest and mitigates the distortions in the economy
that stem from the learningbyinvesting spillovers.
5 Foreign Reserve Accumulation
If government cannot target subsidies directly to capital accumulation or to specific
capitalintensive sectors of the economy, then foreign reserve accumulation may be a
viable secondbest alternative to increase returns in the tradable sector and stimulate
private investment. More formally, we assume the following two restrictions on the
government's set of instruments:
Restriction 1 Government cannot distinguish profitable private investments from
socially wasteful subsidyseeking investments.
17
If government purchases of capital were financed by distortionary taxation, then the aggregate
capital stock would actually decline, as both the income effect of future transfers from governmental
capital income and the tax distortion would induce decentralized agents to invest less.
17
This restriction makes it impossible to subsidize capital accumulation.
Restriction 2 Government cannot distinguish proper tradable goods from subsidy
seeking scams.
Restriction 2 prevents the government from directly targeting subsidies to the tradable
sector, which is more capitalintensive.
By accumulating foreign reserves government can "outsource" these targeting
problems to foreigners. In an environment where capital accounts are closed, i.e.
where private agents are not allowed to borrow or lend abroad, accumulating foreign
reserves is tantamount to granting credit to foreigners to finance exports of domestic
tradable goods.This reduces the quantity of tradable goods in the economy and there
fore increases their price, i.e. it depreciates the real exchange rate. Since the tradable
sector is more capitalintensive, a depreciated real exchange rate raises the returns to
capital and provides incentives for domestic agents to raise investment closer to the
socially optimal level.
Suppose that government accumulates foreign reserves by providing loans to for
eigners to purchase a quantity V of tradable goods. Assume furthermore that the
government revenue necessary to finance these loans is raised via lumpsum taxa
tion.18 Denoting the quantity of intervention as a fraction v of domestic tradable
production so that V = v ˇ FT (ˇ), the market clearing condition for tradable goods
(13) is modified to T = (1  v) FT (KT , LT ). As a result, the equilibrium condition
(9) for the final goods sector is divided by the factor (1  v):
FN (KN , LN ) q
q (v) = ˇ =
1  FT (KT , LT ) (1  v) 1v
Running a current account surplus appreciates the real exchange rate by making
tradable goods in the economy scarcer. Using this modified final goods equilibrium
condition we can express the optimal ratios of capital and labor employed in the
intermediate goods sectors as
(v) = (1  v) and (v) = (1  v) (27)
The two ratios decline in v as factors flow into the tradable sector so as to make
up for the domestic shortage of tradable goods that results from the government's
exports. In other words, the more the government raises v, the higher the demand
for tradable intermediate goods and therefore the lower the fraction of both capital
18
In practice, the accumulation of foreign reserves often occurs through "unsterilized intervention,"
i.e. the government finances the additional exports with newly issued domestic currency. This implies
that the source of finance for V is effectively seigniorage, leading to higher inflation and distorting
the level of money holdings in the economy. However, our model does not include nominal variables
and we do not specify in the detail the precise source of government revenue.
18
UDE USP SP
25%
20%
15% SP
10%
DE
5%
V
DE
0%
VV
A
A
30% 40% 50% 60% 70% 80%
Figure 2: Effects of current account intervention
and labor allocated to the nontradable sector. We denote the domestically available
social product of capital under current account intervention as
AV (v) = (1  v) A ((v), (v))
Exporting of fraction v of tradable intermediate inputs leaves a fraction (1  v) for
domestic production, which entails a firstorder decline in final goods production.
However, the private interest rate that results from this policy is
+ (1  v)(1  )
R (v) = ˇ A ((v), (v))
(1  v)1
The factor premultiplying A(ˇ) in this expression captures the share of intermediate
goods output that accrues to capital. As long as assumption 1 ( > ) is satisfied,
this factor experiences a firstorder increase in accordance with the StolperSamuleson
theorem (see appendix A.4 for a detailed derivation). The factor A((v), (v)) ex
periences a second order decline as the intervention distorts the optimal allocation
of factors into the tradable/nontradable goods sectors. For small v, this entails a
firstorder increase in the interest rate and by extension in the economy's growth rate.
The total welfare effects of current account intervention depend on the relative
magnitude of the dynamic welfare gain from mitigating the learningbydoing exter
nality and raising the growth rate compared to the static welfare loss from giving
up a fraction of tradable goods that could otherwise be consumed/invested. Figure
2 depicts the effects of current account intervention graphically: increasing v corre
sponds to a movement upwards and to the left along the V V curve, starting from the
decentralized equilibrium DE. As long as the V V curve is steeper than the agent's
isoutility curves, the static welfare loss (i.e. the movement to the left) is more than
19
offset by the dynamic gain from higher growth (i.e. the upwards movement). The
slopes of the isoutility curve and of the V V curve in the decentralized equilibrium is
reported in table 1 for different parameter values, together with a comparison of which
of the two curves is steeper. The optimum amount of current account intervention
can be determined as the point where the V V curve is a tangent to the representative
agent's isoutility curves, as indicated by the point V in the figure.
Analytically, we determine the slope of representative agent's indifference curves in
the decentralized equilibrium by implicitly differentiating the agent's welfare function
¯
(25) for constant welfare U ,
d 1  (1 + )1
=
dA ¯
U (1 + A  ) (1 + )  1
Similarly, the output/growth tradeoff of current account intervention is captured by
the slope of the V V locus (see appendix for details),
1
d d/dv (1  )(~  )
= = 1
dAV (v) v=0 dAV (v)/dv v=0 (1 + R  )
Definition 3 (Tradedependent economy) We call an economy tradedependent
if the dynamic growth benefit from removing tradable goods from the economy is larger
than the static welfare loss in the decentralized equilibrium.
This is the case whenever the representative agent's indifference curve in the de
centralized equilibrium is more negatively sloped than the output/growth tradeoff
locus of current account intervention, or analytically
d V d
>
dA ¯
U dA VV
Proposition 4 A small current account surplus of amount V depreciates the real
exchange rate q, raises the private returns on capital R and increases the growth rate
in the economy. If the economy is tradedependent (definition 3), this raises welfare.
Table 1 illustrates the desirability of current account intervention for a wide range
of parameters. The first six columns report the parameter values used for the economy,
where we target A by adjusting AZ appropriately. The next three columns report
~
the resulting aggregate capital share as well as the growth rates in the economy's
decentralized equilibrium and the social optimum. The last three columns report the
marginal dynamic utility gain from increasing the growth rate by raising the amount of
intervention M U(v) , the marginal static utility loss from the resource loss that occurs
when v is increased M UA(v) , and the optimal v , if available. (If the static loss from
undervaluation already exceeds the dynamic gain in the decentralized equilibrium,
then no welfareimproving amount of reserve accumulation v > 0 is available.)
20
A ~
DE M U(v) M UA(v) v
Benchmark economy
0.4 0.8 0.3 0.4 0.96 1 0.50 7.5% 22.08 16.34 0.28
0.4 0.8 0.6 0.4 0.96 1 0.68 14.4% 7.44 22.77 .
0.4 0.4 0.3 0.4 0.96 1 0.34 1.4% 4.93 13.06 .
0.4 0.9 0.5 0.4 0.96 1 0.66 13.7% 15.24 21.82 .
0.4 0.5 0.2 0.4 0.96 1 0.32 0.6% 14.97 12.74 0.22
Relatively closed economy
0.2 0.8 0.3 0.4 0.96 1 0.40 3.7% 15.81 7.06 0.68
0.2 0.8 0.6 0.4 0.96 1 0.64 12.9% 5.19 10.47 .
0.2 0.4 0.3 0.4 0.96 1 0.32 0.6% 3.33 6.37 .
0.2 0.9 0.5 0.4 0.96 1 0.58 10.6% 11.02 9.34 0.27
0.2 0.5 0.2 0.4 0.96 1 0.26 1.7% 10.35 5.94 0.68
Patient economy
0.4 0.8 0.3 0.4 0.975 1 0.50 9.2% 60.36 28.07 0.44
0.4 0.8 0.6 0.4 0.975 1 0.68 16.2% 21.03 40.56 .
0.4 0.4 0.3 0.4 0.975 1 0.34 3.0% 13.26 22.04 .
0.4 0.9 0.5 0.4 0.975 1 0.66 15.4% 42.85 38.65 0.08
0.4 0.5 0.2 0.4 0.975 1 0.32 2.2% 40.20 21.46 0.51
Lower elasticity of substitution economy
0.4 0.8 0.3 0.4 0.96 2 0.50 3.7% 9.00 26.92 .
0.4 0.8 0.6 0.4 0.96 2 0.68 7.0% 1.40 24.90 .
0.4 0.4 0.3 0.4 0.96 2 0.34 0.7% 5.39 35.06 .
0.4 0.9 0.5 0.4 0.96 2 0.66 6.6% 3.11 24.94 .
0.4 0.5 0.2 0.4 0.96 2 0.32 0.3% 19.34 37.12 .
Table 1: Optimal reserve accumulation for selected parameter values
21
The table is split into four blocks, each of which consists of five lines. The five lines
within each block reflect alternative values of the capital intensities and in the two
intermediate goods sectors. The first line assumes an economy with a nontradable
sector of standard capital intensity of 0.3, whereas the tradable sector is considerably
more capitalintensive, .8, reflecting e.g. a higher importance of human capital in that
sector. In lines 2 and 3, we narrow the gap between the tradable and nontradable
capital intensities by raising the nontradable capital intensity/reducing the tradable
capital intensity. Lines 4 and 5 increase/lower the capital intensities in both sectors
in tandem. The resulting aggregate capital share in the economy is reflected by ; it ~
has an important impact on the growth rate DE in the decentralized equilibrium as
agents internalize a smaller or larger share of the social product of capital A .
Block 1 contains what we employ as our benchmark economy, reflecting a size of
the tradable sector of .4, which is a standard value in the literature (see e.g Mendoza,
2005). We chose a value of A = 0.4 for the social product of capital to obtain growth
rates in the decentralized equilibrium that vary within a reasonable range of values
observed in developing countries, from 0% to 14%. In our benchmark configuration,
the table shows that the dynamic gain M U(v) exceeds the static loss M UA(v) of
reserve accumulation only in lines 1 and 5, i.e. for economies with capital shares
that differ significantly between tradable and nontradable sectors but are relatively
~
low < .5 in aggregate. The relatively low aggregate capital share implies that
there are significant learningbyinvesting externalities; the large difference in capital
intensities implies that policy measures that affect the real exchange rate have a large
StolperSamuelson effect on the returns to capital.
In block 2 we represent a relatively closed economy with a value share of tradables
of = .2. This significantly lowers the cost of intervention, as a given amount of
tradables exported can achieve a larger movement of the real exchange rate in the
domestic economy. As a result intervention is also desirable for the economy with
parameters in line 4, in which the aggregate capital share is relatively high.
Block 3 repeats our calculations for an economy that is more patient than the
benchmark, with = .975. Since agents discount the future at a lower rate, the
dynamic utility gains from higher growth M U(v) increase significantly. (Since M UA(v)
captures the present discounted value of all future static losses, it also rises in absolute
value, but by less than the dynamic utility gain.) Foreign reserve accumulation is
desirable under the same circumstances as in the relatively closed economy.
Finally, block 4 captures an economy with a lower intertemporal elasticity of sub
stitution = 2. This reduces the dynamic gains from future growth significantly, as
agents are less willing to substitute current for future consumption. Current account
intervention is undesirable in all five lines of this block. One interpretation of this
result is that exchange rate undervaluation is most desirable in countries where poli
cymakers place an important weight on future growth and are highly willing to give
up current consumption for this goal.
22
Our quantitative results are derived under the assumption that tradable goods are
permanently removed from the economy and provide no future benefit to domestic
agents. This is of course an extreme assumption. In particular, if the country also
derives insurance benefits from holding reserves, or if the learningbyinvesting exter
nalities cease at some point, say when the economy has reached the world technology
frontier (Acemoglu et al., 2006), then reserves can be repatriated without jeopardiz
ing future growth and yield significant utility benefits that we have not captured in
our specification.19 Under such circumstances, undervaluation through reserve accu
mulation is a fortiori desirable under much weaker conditions than what we found
above in table 1.
Relationship to Trade Policy Measures
The role of current account intervention in our setup is to induce foreigners to remove
tradable goods from the domestic economy so as to push up their relative price and
increase the return on capital, thereby solving a targeting problem. Foreigners ensure
that only firms that indeed produce useful tradable goods and that are productive
enough to export (see e.g. Melitz, 2003) will benefit from the sectoral subsidy created
by current account intervention. This avoids the selection problems that arise for
most government policies targeted at a specific sector.
However, the growth channel through which current account intervention affects
welfare in our setup is fundamentally distinct from standard channels of restrictive
trade policy. Import tariffs, for example, take advantage of a country's monopsony
power; they aim to push down the relative world market price of a country's imports
in terms of its exports so as to improve the country's terms of trade. In doing so
they discriminate between domestically and foreign produced tradable goods. By
contrast, in our setup there is no role for terms of trade effects, since there is a single
homogenous tradable good.20
If the economy under consideration was large compared to the rest of the world,
the only international price that reserve accumulation in our model would affect is
the international interest rate, since the domestic government increases the supply of
credit to the world economy. However, we assumed the economy is small compared
to the rest of the world and takes the world interest rate as given.
19
If the learningbydoing externality is still active when reserves are decumulated and tradable
goods are repatriated, this would trigger the same effects that we described in reverse: importing
large amounts of tradable goods would appreciate the real exchange rate, depress the domestic
interest rate and reduce capital accumulation and growth.
20
More generally, if there were multiple tradable goods in the world economy and the country
under consideration had market power over its exports, export subsidies would lower the world
market price of the country's exports and would deteriorate the domestic country's terms of trade.
While this would raise aggregate welfare in importing countries, it typically draws heavy criticism
from those sectors in importing countries that are hurt by the measure. These open economy
considerations are not the focus of the present paper.
23
5.1 Capital account openness and capital flows
So far we have assumed that the capital account of the economy under consideration
is closed for all agents except the government. We abstracted from all forms of private
intertemporal trade.
Let us now investigate whether and under what circumstances capital account
restrictions are indeed desirable in our model. Assume that the economy described
so far is a small open economy that faces an exogenous world interest rate of rw , and
let us analyze the role of capital flows in this context.
In our model economy with learningbydoing externalities, we discussed that the
aggregate prodution technology is A K, i.e. linear in the economy's capital stock.
This implies that the normal equilibrating mechanism that results from decreasing
returns to scale (i.e. that the rate of return is a decreasing function of the capital stock)
is not present. However, there is a different equilibrating mechanism at work: when
the world interest rate is higher (lower) than the interest rate faced by decentralized
agents in the small open economy, they have incentive to lend (borrow) abroad by
exporting (importing) tradable intermediate goods. As the quantity of tradable goods
in the economy in a given period shrinks (rises), the same forces that we discussed
above will raise (lower) the returns to capital.
More specifically, assume that the interest rate in the domestic economy is above
the world interest rate; this implies that tradable goods will flow into the economy;
the relative price of tradable goods will fall; since tradable goods are more capital
intensive, a StolperSamuelsonlike effect will entail a decline in the interest rate. This
process will take place until domestic and foreign interest rates are equalized. Given
constant parameter values, note that capital market equilibrium in such an economy
would require a persistent trade deficit to equalize rates of return. At some point it
is likely that borrowing constraints on the domestic economy become binding and/or
lead to an increase in domestic interest rates and the flow of resources stops.
Depending on the level of the world interest rate rw , we distinguish three cases:
Case 1: rw A  If the world rate of interest is greater than the economy's social
return on capital net of depreciation, then it would be optimal for the economy
to lend abroad, i.e. to export tradable goods. The reduction in the domestic
availability of tradable goods will raise the domestic return on capital until
the return differential vanishes. Note that this case is rather unlikely, since A
captures the social returns on capital, i.e. both wages and the private return
on capital, whereas the private interest rate rw captures only private returns on
capital.
Case 2: A  > rw A  If capital flows were deregulated, decentralized agents
~
would export capital so long as the private net return on capital R = A  ~
w
is less than the world interest rate r . Given assumption 1, the resulting outflow
of tradable goods would increase the private return on capital until equilibrium
24
is obtained when R  = rw . However, since decentralized agents internalize
only the private returns to capital and not the increased wage earnings obtained
from a higher capital stock, the resulting capital outflow is socially inefficient
and reduces the economy's welfare. A social planner would recognize that the
social return on domestic capital is in fact higher than the world interest rate.
This would create a strong rationale for keeping the economy's capital accounts
closed for private agents so as to restrict capital flight.
Case 3: A  > rw Finally, if the world interest rate is less than the economy's
~
private net return on capital, decentralized agents would want to borrow abroad
and increase their capital stock. Any capital inflow would entail not only higher
earnings on capital, but via the learningbyinvesting externality it would also
raise wages.
5.2 Resource curse
Our model is also well suited to study the effects of exogenous changes in the do
mestic supply of tradable goods, such as what is captured by the socalled resource
curse, aid curse, or by a surge in private capital flows into the country. Analytically,
an exogenous increase in the supply of tradables represents the direct opposite of a
government policy of reserve accumulation, as analyzed earlier in section 5. We can
interpret a sudden discovery of resources or a surge in aid inflows as an additional ex
¯
ogenous supply of tradable goods T , which implies that the market clearing condition
¯
for tradable intermediate goods becomes T = T + FT (KT , LT ).
The situation can be analyzed in terms of the model laid out earlier in this section
¯
if we set v = T /FT . In particular, an exogenous inflow of tradable resources will
entail a static welfare gain for the economy as the total amount of resources available
rises, but the economy will suffer a dynamic loss as the increased supply of tradable
intermediate goods reduces the domestic return on capital and pushes factors into the
production of nontradables. (Note that what matters for this conclusion is not the
capital intensity of natural resources, but the capital intensity of those tradable goods
that were previously domestically produced and are imported after the discovery of
natural resources.)
¯
Corollary 5 In an tradedependent economy, a small exogenous inflow T of tradable
resources unambiguously reduces welfare.
A direct implication of this finding is that if reserve accumulation improves welfare
in a given economy, then untied foreign aid unambiguously reduces welfare.
25
6 SectorSpecific Interventions
As the institutional capacities of a government develop, its ability to implement well
targeted taxes and subsidies may improve. In particular, it is common practice among
industrialized countries that specific government policies are targeted at specific sec
tors. This section investigates the scope for secondbest government intervention if
we continue to assume government faces restriction 1 (on targeting investment), but
drop restriction 2 (on targeting specific sectors).
This opens the possibility for government to engage in secondbest policies that
share the following feature: they raise the private returns to capital R and induce
decentralized agents to invest more, which increases the economy's growth rate
above DE and leads to a first order welfare gain. They do so at the cost of introducing
a distortion into the economy's factor allocation that reduces the social product of
capital A below the optimum level A . In figure 3 this corresponds to a movement
upward and to the left of the decentralized equilibrium DE along the T T curve.
Such policies raise welfare as long as the dynamic welfare gain from higher growth
justifies the static loss in productivity, i.e. as long as d/dAT T along the secondbest
frontier is steeper than the slope of the indifference curve d/dAU at a given point
(, A). The optimum level of government intervention is is reached at the point of
the TT curve where the two slopes coincide, i.e. where the respective isoutility curve
forms a tangent to the TT locus. In the following we apply this principle to a range
of secondbest government policies.
6.1 Differential taxation of intermediate goods
We start by assuming that government levies differential taxes/subsidies ( T , N ) on
the purchase of tradable and nontradable intermediate goods for final production,
where subsidies are represented by negative tax rates. The optimization problem of
final goods producers can be expressed as
max AZ T N 1  (1 + T ) pT T  (1 + N ) pN N
T,N
which yields the two firstorder conditions
1
N
FOC(T ) :AZ = (1 + T )pT (28)
T
T
FOC(N ) :(1  )AZ = (1 + N )pN
N
Dividing the two firstorder condition, we obtain the equilibrium condition (F F ) for
the final goods sector, which in the case of differential taxation of intermediate
goods reads as
pT 1 + N N
q= = ˇ ˇ (29)
pN 1  1 + T T
26
UDE USP SP
25%
20%
15% SP
10%
DE
5% T
TT
DE
0%
A
A
40% 50% 60% 70% 80%
Figure 3: Isoutility curves in (A, )space
The optimization problem of intermediate goods producers is unaffected; hence the
equilibrium conditions (RR) and (ww) for factor markets remain unchanged. We can
combine these with the modified final goods market condition (29) to find that the
effect of intermediate goods taxation on the capital and labor ratios of the two sectors
is
1 + T 1 + T
( T , N ) = ˇ and ( T , N ) = ˇ
1 + N 1 + N
Naturally, the greater the tax T > 0 on tradable goods relative to the tax on
nontradables goods N , the higher the fraction of factors allocated to the nontradable
sector. By the same token, the greater (in absolute value) the subsidy T < 0 to the
tradable sector, the higher the fraction of factors allocated to that sector. Since the
sectoral factor allocations and in the decentralized equilibrium were socially
optimal, reallocating them through tax policy introduces a secondorder distortion
into the economy that lowers the aggregate social return on capital to21
A = A(( T , N ), ( T , N )) A
with strict inequality whenever T = N . The resulting interest rate is
[1 + ( T , N )] (1  )
R( T , N ) = ˇ A = + ˇ A (30)
1 + T 1 + T 1 + N
A tax (subsidy) on either intermediate goods sector lowers (raises) the returns to
capital. The return to capital R in this expression consists of the sum of the returns
21
This follows directly from the envelope theorem: since and were chosen to maximize
A (, ), small changes to the two parameters entail only secondorder deviations from A .
27
to capital in the tradable and in the nontradable sector, where the relative weights
and (1  ) reflect the shares of tradable capital and nontradable capital in
final goods production ( is the capital share in tradable goods and is the share of
tradables in final goods, and similarly for nontradable goods).
If the two tax rates (subsidies) are identical T = N , then the measure is equiva
lent to a general tax Z (or subsidy sZ ) on production and the condition collapses to
R = A /(1 + Z ), as discussed in section 4 on firstbest policy measures. In general,
~
such policy measures require that government can rebate the tax revenue (or raise
the revenue required for the subsidy) in a lumpsum fashion. In the following we
analyze the potential to manipulate the relative price of intermediate goods through
a revenueneutral pair of taxes/subsidies on intermediate goods.
Revenueneutral taxes/subsidies on intermediate goods
Definition 6 A pair of sectoral taxes/subsidies ( T , N ) on intermediate goods is
revenueneutral if
N pT T
T pT T + N p N N = 0 or = (31)
T pN N
Each revenueneutral pair ( T , N ) defines a unique wedge between the prices of
tradable and nontradable goods in expression (29). Furthermore, we find:
^
Lemma 7 Any pair (^T , N ) that does not satisfy restriction (31) can equivalently
be represented as a revenueneutral pair ( T , N ) together with a uniform tax/subsidy
on final goods production Z .
The economic effects of Z have already been analyzed in corollary 2 in the section
on firstbest policy measures.
Since the value shares of the two intermediate goods entering final goods produc
tion is constant, a revenueneutral pair ( T , N ) satisfies (see appendix A.5)
T
N =  (32)
1  + T
In other words, picking a positive subsidy  T defines a unique tax N such that the
measure is revenueneutral and vice versa.22
The effects of such a measure on the private interest rate R and by extension on
growth are described by the following proposition (see appendix A.5 for a proof):
Proposition 8 A small revenueneutral pair ( T , N ) of subsidies on tradable goods
T < 0 and taxes on nontradable goods N > 0 raises the private interest rate and
stimulates growth if and only if assumption 1 is satisified, i.e. if > .
22
This holds as long as the subsidies satisfy T >  (1  ) or N >  respectively. Subsidies
that violate these conditions are too expensive to be financed by taxes levied exclusively on the other
sector.
28
A DE T N A/A U
0.4 0.8 0.3 0.4 3.69% 0.20 0.20 1.50% 4.46% 3.92%
0.4 0.8 0.6 0.4 6.97% 0.04 0.03 0.05% 7.03% 0.13%
0.4 0.4 0.3 0.4 0.69% 0.08 0.06 0.24% 0.74% 0.54%
0.4 0.9 0.5 0.4 6.61% 0.10 0.08 0.33% 6.89% 0.70%
0.4 0.5 0.2 0.4 0.3% 0.21 0.22 2.03% 0.78% 5.99%
Table 2: Sectoral tax/subsidy measures for different parameter values
The different capital intensities among the two sectors imply that the subsidy to
tradable goods falls relatively more on capital, whereas the tax on nontradables falls
relatively more on labor. In other words, the policy represents a redistribution from
labor to capital.The proposition is a version of the Stolper and Samuelson (1941)
theorem: manipulating the relative price of the capitalintensive versus the labor
intensive good moves the relative return to capital compared to labor in the same
direction. In accordance with the Euler equation of decentralized agents (2), a higher
private interest rate R raises the private savings rate and therefore the growth rate
of the economy. Since the decentralized savings and growth rates were suboptimally
low, increasing them entails a firstorder dynamic welfare gain.
Table 2 reports the optimal pair of secondbest taxes/subsidies on intermediate
goods for the same parameter values as in a block of table 1. For each of the cases, we
report the optimal pair of subsidies and taxes ( , ), where negative values repre
T N
sent subsidies, the percentage decline in the social product of capital A/A, as well
as the growth rate under the specified optimal policy. The last column contains the
increase in welfare U in terms of the equivalent permanent increase in consumption
that results from the optimal policy.
Row 1 represents an economy in which the capital intensity of the two sectors
reflects our benchmark case. Given the relatively large difference in capital intensities,
a set of subsidies and taxes in the amount of 20% each is called for, and this raises
the growth rate in the economy by a third of a percentage point while reducing the
social product of capital by 1.5%. The equivalent increase in welfare is close to 4%.
From the remaining examples in the table we can see that a greater difference in
capital intensity among the two sectors makes the optimum size of policy intervention
larger, whereas a larger aggregate capital share in the economy reduces optimal policy
measures, as the economy is already closer to the first best.
We illustrate our findings graphically in figure 3: a subsidy on tradable relative to
nontradable goods moves the decentralized equilibrium along the secondbest fron
tier T T up and to the left. The dynamic growth effect (i.e. the upward movement)
has firstorder positive welfare effects, since the decentralized equilibrium exhibits a
socially inefficient growth rate. The distortion to the sectoral factor allocation that re
duces the social product of capital (i.e. the movement to the left) has a secondorder
welfare cost, since the decentralized equilibrium was characterized by the socially
29
optimal factor allocation between the two sectors. By implication, the policy is un
ambiguously welfareimproving for small tax rates. The point marked by T indicates
the optimal level of subsidies/taxes in the given example, which can be found as the
tangency point of the T T locus with the representative agent's indifference curves.
We have drawn the indifference curve going through this point as a dotted line.
Figure 3 also illustrates the findings of Rodrik (2008), who argues that devel
oping countries suffer from distortions in the appropriability of returns, which are
particularly pronounced in the tradable sector. He models these distortions as a tax
that discriminates against the tradable sector and suboptimally shifts the economy's
factor allocation towards nontradables. In the figure this would be reflected as a
move along the lower arm of the secondbest frontier T T moving down from the
decentralized equilibrium DE. Undoing this distortion by raising the relative price
of tradables (i.e. depreciating the real exchange rate) can restore the decentralized
equilibrium DE and increase welfare because it both improves the sectoral factor
allocation and raises the growth rate by increasing the private return on capital.
While the analysis of Rodrik (2008) addresses the appropriability problem in the
tradable sector, he remains silent on how policy action can induce agents to internalize
the learningbyinvesting externality that is present in both his and our framework.
Addressing this externality is the only way to move the economy closer to the firstbest
equilibrium SP that would be chosen by a social planner.
A subsidy ^T on tradable goods that is financed by a distortionary tax on general
output Z is equivalent to a revenueneutral pair of taxes ( T , N ) where 1 + T =
^
(1 + T ) / (1 + Z ) and N = Z . Following the argument of proposition 8, we find
the following:
Corollary 9 A subsidy on tradable goods that is financed by a general tax Z will
raise the returns to capital and increase growth if and only if > .
6.2 Composition of government spending
Another way of influencing the real exchange rate and thereby affecting the relative
return to capital is through the composition of government spending. Assume that
the government purchases the amounts GT and GN of tradable and nontradable
goods at prevailing market prices every period and employs them to produce a public
good G using a production function
G = FG (GT , GN )
In order to keep our focus strictly on the effects of reallocations in government
spending, we assume that government needs to provide a fixed amount of public
¯
spending G = G to keep the economy running, but any spending beyond this threshold
has no effects on welfare. Furthermore, we assume that government revenue is raised
30
via lumpsum taxation. (We have already discussed the effects of distortionary output
taxation in corollary 2.)
Let us define a frontier GG of factor inputs (GT , GN ) that satisfies the required
¯
level of government spending so that FG (GT , GN ) = G. By reallocating governmen
tal demand for intermediate inputs from nontradable towards tradable goods, the
government can influcence the real exchange rate, the private return to capital, and
growth. However, such reallocations are costly as they involve deviations from the
bundle of inputs that minimizes the cost of public goods provision.
Analytically, we define the fractions of tradable and nontradable production ab
sorbed by the government as gT = GT /FT (ˇ) and gN = GN /FN (ˇ). Market clearing in
the two intermediate goods sectors implies that only the fractions (1gT )FT (KT , LT )
and (1gN )FN (KN , LN ) are available for production of the private final good Z. The
resulting equlibrium condition in the final goods sector is
1  gN FN (KN , LN )
q= ˇ ˇ (FFG )
1  1  gT FT (KT , LT )
The ratios of capital and labor inputs into the two sectors are
1  gT 1  gT
G (gT , gN ) = ˇ and G (gT , gN ) = ˇ (33)
1  gN 1  gN
The more government shifts its absorption of intermediate goods towards one sector,
the more production factors flow into that sector. The resulting level of private final
goods production is
AG (gT , gN )K = (1  gT ) (1  gN )1 A (G (gT , gN ), G (gT , gN )) K
Assume that from a static point of view, the optimal allocation of intermediate
goods between government absorption and final goods production is captured by the
pair
(gT , gN ) = arg max AG (gT , gN ) s.t. ¯
FG (gT FT (ˇ), gN FN (ˇ)) = G
In other words, in the absence of the dynamic externality, the amounts gT FT (ˇ) and
gN FN (ˇ) of intermediate goods would be the cheapest way for government to produce
¯
the required level of spending G. If the government increases its absorption of tradable
goods by moving along its factor input frontier GG, more capital and labor is allocated
to the tradable sector, i.e. and rise. Substituting expressions (33) in the tradable
sector's firstorder condition on capital (35), the private return to capital is
1
1  gN 1  gT
R = + (1  ) ˇ A (G , G )
1  gT 1  gN
The term 1gN captures the StolperSamuelson effect, i.e. that higher demand for
1gT
the capitalintensive good causes a firstorder rise in the rate of return on capital,
31
¯
G DE gT gN AG G U
0.4 0.66 0.33 33% 5% 0.36 0.31 0.28% 5.12% 0.52%
0.4 0.8 0.2 33% 5% 0.4 0.3 1.04% 5.48% 2.14%
0.2 0.8 0.2 33% 5% 0.49 0.3 2.56% 5.93% 4.25%
0.4 0.66 0.33 20% 5% 0.22 0.19 0.1% 5.07% 0.35%
Table 3: Secondbest policy measures for different parameter values
which increases savings and growth. The term AG (gT , gN ) < AG (gT , gN ) captures the
secondorder distortion in the sectoral allocation of capital and labor.
We conclude that a reallocation of government spending towards the tradable
sector achieves a firstorder dynamic growth effect at a secondorder static efficiency
cost. Therefore a small reallocation unambiguously raises welfare.
Graphically, the locus of factor inputs (GT , GN ) that produces the required amount
of government spending looks similar to the T T locus in figure 3. Table 3 illustrates
the optimal reallocation in government spending for economies with different param
eters values for , and and for AZ that is calibrated to yield the indicated growth
rate DE in the economy. In addition we vary the fraction of government spending
¯
in total output as indicated in column 4 by the variable G. In order to simplify the
interpretability of our results, we assume that government spending employs the same
production function (7) as final goods. This implies that the most costeffective way
¯
of producing G is to employ intermediate goods in the same proportions as final goods
¯
producers do, so that gT = gN = G/Z. The columns marked by gT and gN indicate
the optimal shares of intermediate goods that a government following a secondbest
policy chooses. This results in a static distortion AG to the economy's social prod
uct of capital, but a dynamic increase in the growth rate to G . The overall welfare
gain expressed as the equivalent permanent increase in consumption is reported in
the last column.
In the example presented in the first row, the optimal secondbest expenditure
policy uses 36% of the economy's output of tradables and only 31% of nontradables.
This causes output to rise by .12% and leads to a relatively small increase in welfare of
.52%. If we increase the difference in capital intensities among the two sectors (row
2), the government's optimal expenditureswitching policy as well as the resulting
welfare effects are markedly stronger. This holds even more if the tradable sector is
small, as represented by = .2 (row 3). Lastly, it is natural that the smaller the
size of government expenditure, the less significant the effects of sectoral reallocations
(row 4).23
23
More generally, the social cost of sectoral reallocations in government spending and therefore
the optimal level of reallocations also depend on the substitutability of tradable and nontradable
goods in the government's production function FG .
32
6.3 Sectorspecific factor taxation
Another way for government to affect relative prices and the return to capital in the
economy would be by imposing sectorspecific taxes or subsidies on the returns to
the production factors. While this technically violates our restriction 1, our analysis
is highly relevant for economies in which the nontradable sector is predominantly
informal so that all formal policy measures are likely to disproportionately affect the
tradable sector.
We denote the bundle of tax rates on the returns on capital and labor in the
tradable and nontradable sectors as ( T K , T L , N K , N L ), where a negative tax rate
represents a subsidy. We continue to assume that any revenues or costs are rebated
in lumpsum fashion. By repeating the steps outlined in subsection 2.2, we find that
the equilibrium conditions (4) and (5) for the two factor markets are modified to
1 + T K KN (AN LN )1
1
q= ˇ
1 + N K KT (AT LT )1
1
1 + T L (1  ) KN A1 L
N N
q= ˇ
1 + N L (1  ) KT AT L
1
T
Combining these two equations with the equilibrium condition (14) for the final goods
market, which remains unchanged, results in capital and labor ratios of
1 + TK 1 + TL
( T K , N K ) = ˇ and ( T L , N L ) = ˇ
1 + NK 1 + NL
as well as an equilibrium interest rate (see appendix A.6 for details) of
(1  )
R ({ ij }) = + ˇ A (, ) (34)
1 + TK 1 + NK
Taxes on labor enter this expression only indirectly through the social return on
capital A (, ). As can be seen from the expression for ( T L , N L ), the inelastic
labor supply entails that wage taxation is irrelevant for the social return on capital A,
the interest rate R and therefore welfare as long as both sectors are taxed at the same
rate the tax rates in the expression for cancel out and the tax acts as a lump
sum tax. On the other hand, if the tax rates on labor differ across the two sectors,
welfare is unambiguously reduced: labor will be allocated inefficiently between the
two sectors, which introduces a secondorder distortion to the social return on capital
A (ˇ) without any direct effects on the private interest rate R (ˇ). This lowers both
the return to capital and growth in the economy.
By contrast, taxing (subsidizing) the returns to capital in any sector reduces (in
creases) the economywide interest rate and by implication savings, with the strength
of the effect depending on the capital share of the relevant sector, as specified by
equation (34). If the tax rates on capital in the two sectors differ, a secondorder
33
static distortion is introduced into the sectoral capital allocation, as captured by the
expression for ( T K , N K ). Furthermore, note that taxing nontradable capital and
subsidizing tradable capital (or vice versa) in a revenueneutral fashion does not have
a firstorder effect on the interest rate, since capital is unspecific in our model: the
aggregate return to capital cannot be increased by taking from capital owners and
giving back to them; such a policy only introduces a secondorder distortion into the
economy.
More generally, any bundle of sectorspecific factor taxes can equivalently be repre
sented as a pair of taxes on capital and labor ( K , L ) together with a revenueneutral
pair of taxes on intermediate goods ( T , N ). The effects of these two sets of policy
measures are discussed in sections 4 and 6.1 respectively.
Our analysis of sectorspecific factor taxation suggests that in countries in which
the nontradable sector is predominantly informal (e.g. small shops and street ven
dors) and therefore difficult to subject to taxes or subsidies, subsidizing (formal)
tradable capital and raising the revenue by taxing (formal) tradable labor would
constitute another secondbest policy option: the policy would achieve a firstorder
increase in the private return to capital (in both sectors, since capital is unspecific)
at the cost of secondorder distortions to the capital ratio (as excess capital flows
into the formal tradable sector to take advantage of the subsidy) and the labor ratio
(as labor flees into the informal nontradable sector to avoid taxation).
7 Conclusions
This paper has established conditions under which policy measures to undervalue a
country's real exchange rate generate dynamic gains in terms of increased economic
growth by internalizing learningbyinvesting externalities. Our findings depend on
two critical properties, (i) that technological progress in the economy is subject to
learningbyinvesting externalities and (ii) that the tradable sector in the economy
is more capitalintensive and therefore generates a disproportionate amount of these
externalities.
If firstbest policy measures are are not feasible because of targeting problems, or
because multilateral agreements constrain taxcumsubsidy measures, reserve accu
mulation may be desirable if certain deep parameter restrictions are met regarding
the magnitude of growth externalities, the relative capitalintensity and size of the
tradable sector, the willingness of agents to intertemporally smooth and their rate
of time preference. The conditions under which it is desirable for a country to ac
cumulate reserves are identical to those under which countries suffer from a foreign
aid curse or resource curse when they experience an exogenous inflow of tradable
resources.
Our paper analyzes these issues from the perspective of a small open economy that
does not affect equilibrium in world capital markets. An interesting next step on our
research agenda is to evaluate the welfare effects of real exchange rate undervaluation
34
in a given country on other countries. In a twocountry setting, we conjecture that
reserve accumulation in a country that is subject to learningbyinvesting externalities
may constitue a Pareto improvement if the second country is free of such growth
externalities, as the second country benefits from a lower world interest rate and the
first country from internalizing the externality. In turn, in a multicountry setting,
all countries that exhibit learningbyinvesting effects impose negative externalities
on each other when they engage in reserve accumulation, whereas countries free of
growth externalities benefit from other countries' reserve accumulation.
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A Mathematical Appendix
A.1 Equilibrium Conditions for Firms
We express the first order conditions of tradable firms as functions of the product
rent and the product wage,
R
KT (AT LT )1 =
1
(35)
pT
w
(1  ) KT A1 L
T T = (36)
pT
and similarly the first order conditions for nontradable firms,
R
KN (AN LN )1 =
1
(37)
pN
w
(1  ) KN AN L
1
N = (38)
pN
Dividing the first order conditions on capital yields equilibrium condition (4) for
the capital market; dividing the remaining two conditions yields the equilibrium con
dition (5) for the labor market.
The final goods sector's first order conditions imply that the marginal product of
each intermediate input has to equal its price,
1
N
AZ = pT (39)
T
T
(1  ) AZ = pN (40)
N
37
Combining the two conditions we obtain equilibrium condition (14) for the final goods
sector.
A.2 Aggregate Production Technology
If we substitute for the endogenous levels of technology (6) and the private factor
allocations (15) and (16) in the tradable and nontradable production functions and
assemble the two intermediate goods into final goods using production function (7),
it can be seen that the economy's combined production technology is
1
A (, ) = FZ (T, N ) /K = AZ KT (KLT )1
KN (KLN )1
/K =
1 1 1
1 1
= AZ
L1~
1+ 1+ 1+ 1+
where we substituted the definition of the aggregate weighted capital share = ~
+ (1  ) to obtain the expression in equation (19). If the capital and labor ratios
are at the socially optimal levels and , this expression can be further reduced to
() [(1  ) ](1) [ (1  )](1) [(1  ) (1  )](1)(1) 1~
AZ ˇ L
~~ (1  )~
1~
A.3 Public accumulation of capital
We extend the model of investment and capital accumulation from section 2.1 by
labeling private investment and capital I P and K P and by introducing governmental
investment I G and capital K G that follow a law of motion similar to that of private
capital, i.e.
G
Kt+1 = (1  )KtG + ItG
Assuming that government investment I G is financed by lumpsum taxes and the
returns on governmental capital are distributed to agents in lumpsum fashion, the
representative agent's budget constraint can be expressed as
P G
Ct = KtP + KtG (1 + Rt  ) + w  Kt+1 + Kt+1
Substituting this into the agent's maximization problem (1) and taking the firstorder
condition with respect to private capital Kt we find the Euler equation
Ct 1
= [(1 + Rt  )]
Ct1
This optimality condition is identical to the decentralized agent's Euler equation (2)
in the absence of government intervention. Furthermore, if the series of values for
38
the capital stock {Kt } is the solution to the decentralized maximization problem,
t=0
then any series {KtP + KtG } where KtP + KtG = Kt solves the modified problem
t=0
with governmental accumulation of capital. In other words, for every increase in the
governmental capital stock K G , private agents reduce their capital stock K P by an
identical amount so as to solve their optimization problem public investment fully
crowds out private investment.
A.4 Effects of Current Account Intervention
We derive the expression for the price of tradable goods from (39) using the modified
equilibrium condition (27) for the final goods sector:
1
FN (ˇ)
pT (v) = AZ
(1  v)FT (ˇ)
The equilibrium interest rate can then be derived from (35) as
FT (ˇ) AZ 1 + (v)
R(v) = pT = ˇ ˇ FT (ˇ) FN (ˇ)1 =
KT (1  v)1 KT
+ (1  v)(1  )
= ˇ A ((v), (v))
(1  v)1
Small interventions v introduce a distortion into the capital/labor allocation, which
reduces A((v), (v)). However, since (v) and (v) are chosen optimally given
the intervention, the envelope theorem implies that this effect is second order and
dA(ˇ)/dvv=0 = 0. On the other hand, the factor premultiplying A(ˇ) experiences
a firstorder increase so that the interest rate under current account intervention is
larger than the free market interest rate,
dR(v) (1  v) + [ + (1  )(1  v)]
= (1  ) ˇ A =
dv v=0 (1  v)2 v=0
= (~  )(1  )A > 0
which is positive as long as the capital share in the tradable sector is larger than in
the nontradable sector, as we assumed in assumption 1.
The slope of the V V locus at v = 0 can be expressed by the implicit function
theorem as dAV = dAV /dv where
d d/dv
dAV
= A
dv v=0
d 1 1 1 dR(v)
= (1 + R  ) ˇ
dv v=0 dv
39
A.5 Differential taxation of intermediate goods
We first derive the expression linking a subsidy on tradables to a tax on nontradables
such that the pair ( T , N ) is revenueneutral. For this, combine the revenueneutrality
condition (31) with the equilibrium condition in the intermediate goods market (29)
to find
N pT T 1 + N
 = = ˇ
T pN N 1  1 + T
(1  ) (1 + T ) N =  (1 + N ) T
T
N = 
1  + T
(1  ) (1 + T )
or 1 + N =
1  + T
We substitute this into equation (30) and find:
+ (1  + T )
R( T , N ) = ˇ A
1 + T
Note that the social product of capital A is only affected to a secondorder degree
by taxing/subsidizing intermediate goods and equals A for T = N = 0. If we
differentiate the interest rate with respect to T , we therefore find that for small
revenueneutral sectoral taxes:
dR( T , N ) (1 + T )   (1  + T )
= A + O2 ( T ) =
d T (1 + T )2

= A + O2 ( T )
(1 + T )2
As long as > (assumption 1) is satisfied, a small revenueneutral tax (subsidy)
on tradable production lowers (raises) the private return to capital.
A.6 Sectorspecific factor taxation
Since there is no distortion in the production of final goods, we obtain the price of
tradables pT from equation (39) and substitute this into the expression for the interest
rate that follows from the firstorder condition on tradable capital (35) with a tax
rate T K :
1
T N (1 + ) T
R ({ ij }) = ˇ = AZ =
1 + T K KT 1 + TK T K
(1 + )
= A (, ) =
1  TK
(1  )
= + ˇ A (, )
1 + TK 1 + NK
40