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Extrapolative Expectations and Capital Flows during Convergence

Cozzi, Guido and Davenport, Margaret (2017): Extrapolative Expectations and Capital Flows during Convergence. Published in: Journal of International Economics , Vol. 108, (September 2017): pp. 169-190.

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Abstract

How long shall a country take to learn the world technological frontier? What would happen if that country found the same difficulties in learning the true model of its economy? After all, countries catching up often experience life-changing transformations during the catch-up to a balanced growth path. We show that an open economy, learning rational expectations alongside foreign technology, may be characterized by excessive saving and current account surpluses, as often observed in the data and at odds with the standard open economy theoretical predictions, and not fully explained by standard adaptations such as habit formation. Moreover, such a learning process in a large developing country can upset the savings behavior of a fully rational expectations advanced country. In a US-China calibration, we show that this effect can be so strong as to explain important current account imbalances, the savings glut hypothesis, as well as the distribution of factor income.

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