Real Interest Rates and Productivity in Small Open Economies

54 Pages Posted: 31 Dec 2018

See all articles by Tommaso Monacelli

Tommaso Monacelli

Bocconi University - Department of Economics

Luca Sala

University of Bocconi - Innocenzo Gasparini Institute for Economic Research (IGIER)

Daniele Siena

Banque de France

Multiple version iconThere are 2 versions of this paper

Date Written: December 2018

Abstract

In emerging market economies (EMEs), capital inflows are associated to productivity booms. However, the experience of advanced small open economies (AEs), like the ones of the Euro Area periphery, points to the opposite, i.e., capital inflows lead to lower productivity, possibly because of entry of less productive firms. We measure capital flow shocks as exogenous variations in world real interest rates. We show that, in the data, lower real interest rates lead to lower productivity only in AEs, whereas the opposite holds for EMEs. We build a business cycle model with firms' heterogeneity, financial imperfections and endogenous productivity. The model combines a cleansing effect, stemming from capital outflows (inflows), with an original sin effect, whereby capital outflows (inflows), via a real exchange rate depreciation (appreciation), decreases (increases) the opportunity cost of producing for less productive firms and the borrowing ability of the incumbent, marginally more productive firms. The estimation of the model reveals that a low trade elasticity combined with high (low) firms' productivity dispersion in EMEs (AEs) are crucial ingredients to account for the different effects of capital flows across groups of countries. The relative balance of the cleansing and the original sin effect is able to simultaneously rationalize the evidence in both EMEs and AEs.

Keywords: World Interest Rates, Financial Frictions, Firms' Heterogeneity, Small Open Economies

JEL Classification: F32, F41

Suggested Citation

Monacelli, Tommaso and Sala, Luca and Siena, Daniele, Real Interest Rates and Productivity in Small Open Economies (December 2018). Banque de France Working Paper No. 704. Available at SSRN: https://ssrn.com/abstract=3308438 or http://dx.doi.org/10.2139/ssrn.3308438

Tommaso Monacelli

Bocconi University - Department of Economics ( email )

Via Gobbi 5
Milan, 20136
Italy

Luca Sala

University of Bocconi - Innocenzo Gasparini Institute for Economic Research (IGIER) ( email )

Via Roentgen 1
Milan, 20136
Italy
+39 02 5836 3326 (Phone)

Daniele Siena (Contact Author)

Banque de France ( email )

Paris
France

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