Increasing Returns and the Optimality of Open Capital Markets in a Small Growing Economy

This paper examines the welfare consequences of liberalizing capital markets in the presence of increasing returns driven by externalities in knowledge and capital accumulation. Using a revealed preference argument in a continuous-time infinite horizon model, this paper shows that the opening of capital markets can result in welfare deterioration if foreign interest rates are high and capital outflows are likely. Copyright 1993 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.