Income and Substitution Effects of Capital Inflows: A Firm-Level Analysis joint with Felipe Saffie and Kei-Mu Yi

Abstract:

This paper shows that capital inflows affect the reallocation of resources within and across sectors and an economy's long-term outcomes through two forces. First, capital inflows reduce the relative price of capital promoting industries with high capital elasticity, a substitution effect. Second, capital inflows allow consumption smoothing and increase the demand of goods with high income elasticity, an income effect. The strength of these two forces determines the direction of reallocation effects. We provide evidence for these two forces using firm-level census data from the financial liberalization in Hungary, a policy reform that led to capital inflows. We show that firms in capital-intensive industries expand, as do firms in industries producing goods with high income elasticities. On the aggregate the income effect dominates and reallocates resources towards high income elasticity industries, as services. These findings motivate developing a dynamic, firm-level, multi-sector open economy model with varying capital intensities and non-homothetic preferences. We calibrate the model and simulate a capital account liberalization that occurs during the economy's transition to its steady-state. We find that the model can replicate our empirical results, and that the long-run outcomes depend on the extent of the liberalization.