Unbalanced Growth in a Small Economy with Open Capital Markets

This paper shows that in an economy with open capital markets, there exists a force toward unbalanced growth driven by intertemporal substitution of consumption and trade imbalance. We construct a two-sector Ramsey economy composed of a technologically progressive tradable sector and a technologically stagnant nontradable sector. We show that a capital account liberalization in the economy will drive the long-run share of the tradable sector toward one or zero, depending on whether the autarky interest rate is higher or lower than the world interest rate. The difference between the autarky interest rate and the world interest rate ultimately dictates the direction of structural transformation regardless of the progression of the Baumol’s disease that pushes up the relative price and the share of nontradables. Because the autarky interest rate is increasing in the rate of technological progress, our result suggests that cross-country differences in the rate of technological progress may be an important factor in accounting for the diverse patterns of structural change in a financially integrated world.