Catching-Up and Regulation in a Two-Sector Small Open Economy

Emerging economies may grow fast because there is a potential for catching-up. In this paper foreign knowledge spillovers raise productivity of R&D in the exposed sector. The higher the productivity gap the more profitable investment in R&D will be. As a result labor productivity in the production department of the exposed sector rises fast. The sheltered sector realizes no productivity increases but gains because the terms of trade rise in favor of non-tradables. In the long run the rate of growth of the economy converges to the exogenous world growth rate. Capital mobility speeds up the process of convergence at the expense of accumulating foreign debt. Moreover, temporary shocks have permanent effects as the economy exhibits hysteresis in the case of perfect capital mobility. Regulation in the sheltered sector induces mark-up pricing and a decline in the demand for non-tradables. The market for tradables expands, and it becomes profitable to invest in R&D. Regulation of this kind thus enhances economic growth. The results differ whether or not capital mobility is assumed. Maintaining equilibrium on the balance of trade leads to a higher long-run aggregate consumption level, which may explain the often observed reluctance to introduce free international capital mobility