Capital misallocation and economic development in a dynamic open economy

Some countries, such as Canada, Italy, and Mexico, have experienced a higher growth rate of capital per worker but a lower growth rate for GDP per worker compared to the United States. This paper explains these two facts through the lens of a dynamic multisector open economy model where capital flows across countries. In the model, firms face sector-specific distortions on capital and intermediate inputs that influence the actual rate of return on capital and the aggregate total factor productivity (TFP). We calibrate the model to Mexico for the period 2000-2014 and show that changes in sectoral distortions and productivities reduced the actual rate of return on capital, triggering capital accumulation and a reduction in TFP. The results show that aggregate output decreased by 7.3% and aggregate capital increased by 10.6%. From 33 sectors (out of 48) that suffered productivity losses, approximately 50% accumulated more capital. Furthermore, the capital-intensive sectors explain 82% of the capital-output ratio increase.