“Optimal Development Policies with Financial Frictions” by Oleg Itskhoki
Motivated by the observation that many emerging economies pursue active development and industrial policies, we study optimal dynamic Ramsey policies in a standard growth model with financial frictions. We first study a one-sector economy, and then generalize the framework to multiple sectors in order to consider sectoral and exchange rate policies. In the one-sector economy, the optimal policy intervention initially increases labor supply and lowers wages, 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. The use of additional policy instruments, such as subsidized credit, is desirable as well. In the long run, the optimal policy reverses sign. In a multi-sector economy, optimal policy subsidizes sectors with a latent comparative advantage. Furthermore, if tradables sectors are undercapitalized relative to non-tradables, optimal policy compresses wages thereby improving competitiveness, but this does not necessarily imply a depreciated real exchange rate.