INCREASING RETURNS AND THE OPTIMALITY OF OPEN CAPITAL-MARKETS IN A SMALL GROWING ECONOMY

This paper examines the welfare consequences of liberalizing capital m arkets in the presence of increasing returns driven by externalities i n knowledge and capital accumulation. Using a revealed preference argu ment in a continuous-time infinite horizon model, this paper shows tha t the opening of capital markets can result in welfare deterioration i f foreign interest rates are high and capital outflows are likely.