Optimal Development Policies With Financial Frictions

Abstract

Is there a role for governments in emerging countries to accelerate economic development by intervening in product and factor markets? To address this question, we study optimal dynamic Ramsey policies in a standard growth model with financial frictions. The optimal policy intervention involves pro-business policies like suppressed wages in early stages of the transition, resulting in higher entrepreneurial profits and faster wealth accumulation. This, in turn, relaxes borrowing constraints in the future, leading to higher labor productivity and wages. In the long run, optimal policy reverses sign and becomes pro-worker. In a multi-sector extension, optimal policy subsidizes sectors with a latent comparative advantage and, under certain circumstances, involves a depreciated real exchange rate. Our results provide an efficiency rationale, but also identify caveats, for many of the development policies actively pursued by dynamic emerging economies.

Real exchange rate policies for economic development

“…In particular, if the government could identify the learning spillovers associated with each type of activity and if it could use subsidies and lump-sum taxes to finance the subsidies, then there would be a set of subsidies and transfers that would constitute the first best policy response. These policies would entail an appreciation of the real exchange rate (see Itskhoki and Moll, 2014, and see the appendix for the analytical development of this proposition). But if the implementation of these policies is not possible (either because there are severe political economy problems or risks of rent seeking that impede an efficient allocation of subsidies, or there are international regulations that impede the implementation of subsidies in the first place), then there is a key role for real exchange rate policies as second-best policies.…”

Exploitation of Labor? Classical Monopsony Power and Labor's Share

“…In contrast, Galle (2016) shows that pro-competitive reforms in India led to a decrease in convergence because capital constraints were binding for firms. In related theoretical work, Itskhoki and Moll (2017) show that the suppression of wages can be welfare improving, when firms face financial constraints. Empirically, we are the first to estimate the suppression of wages in a developing country, but our analysis is purely positive.…”

Growth Model with Financial Deepening and Productivity Heterogeneity

“…After calibrating Equation to the Japanese economy from 1961 to 1991, we obtain , and γ = 0.83 . We then follow Itskhoki and Moll () to assume the value of 1.06 for φ and set α equal to 0.363…”