Optimal Development Policies With Financial Frictions

Oleg Itskhoki, Benjamin Moll

Research output: Contribution to journalArticlepeer-review

6 Scopus citations

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.

Original languageEnglish (US)
Pages (from-to)139-173
Number of pages35
JournalEconometrica
Volume87
Issue number1
DOIs
StatePublished - Jan 2019

All Science Journal Classification (ASJC) codes

  • Economics and Econometrics

Keywords

  • Industrial and development policies
  • Ramsey-optimal policies
  • collateral constraints
  • stage dependence
  • transition dynamics

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